Understanding Option's TIME VALUE

I�ve previously written a number of posts on Option�s Time Value. Understanding the behavior of time value is very important in options trading.
For your convenience & easier future reference, I put the links of all posts on this topic below, and place this on the top left corner Click the following links to read each of the posts:

1) More Understanding about Options Time Value
2) Main Factors that Affect Option�s Time Value

3) Option�s TIME VALUE � Putting It Together:
a) Part 1: Understanding What It Is
b) Part 2: Main Factors � Degree of Options Moneyness
c) Part 3: Main Factors � Implied Volatility & Time to Expiration
d) Part 4: Behavior

Related Topics:
* FREE Trading Educational Videos You Should Not Miss
* Options Trading Basic � Part 1
* Options Trading Basic � Part 2
* Understanding Implied Volatility (IV)
* Option Greeks
* Learning Candlestick Charts
* Learning Charts Patterns
* Getting Started Trading

Read more »

Option�s TIME VALUE � Putting It Together � Part 4: Behavior

The Behavior of Time Value
As mentioned in Part 3, the Time Value component of an option price will decline or �erode� as expiration is nearing (i.e. Time Decay).

The rate of decline of option�s time-value resulting from the passage of time (i.e. rate of Time Decay) is known as THETA, which is one of the Options Greeks.

Comparing Theta at a certain point of time between ATM (At-The-Money), ITM (In-The-Money) & OTM (Out-of-The-Money) options, Theta is typically highest for ATM options, and gradually decreases as options move towards ITM and OTM.
This is understandable because ATM options have the highest time value component, so they have more time value to lose over time than an ITM or OTM option.

Comparing Theta over time, there are different behaviors between ATM and ITM / OTM options:
For ATM options, as the Time Value component of an option price decreases when the option is approaching expiration, the rate of time value decrease is accelerating (i.e. Theta is increasing) as it is getting closer to expiration.
This means that the amount of time value disappearing from the option price per day gets bigger with each passing day. For ATM option, time value decreases sharply particularly in the last 30 days before expiration.

On the other hand, for both ITM & OTM options, Time Value actually decreases at a decelerating rate as expiration nears. In other words, Theta decreases as the option is approaching expiration.
This means that the amount of time value disappearing from the option price per day gets smaller with each passing day.

This Time Value behavior can be seen in the following graphs:

1) Time Value of ATM Option:






2) Time Value of OTM Option:




Note: Both pictures courtesy of Sigma Options

Therefore, based on the above, we can summarize as follow:

For ATM options, Theta (i.e. the rate of time value decline as the time passes) is typically the highest (as compared to ITM & OTM options), and will be increasing (i.e. the rate of time value decrease is accelerating) as the option is nearing expiration.

For both ITM & OTM options, Theta is relatively lower (than ATM options), and will be decreasing (i.e. the rate of time value decrease is decelerating) as the option is nearing expiration.

The Impact of Implied Volatility (IV) on THETA
Theta will also be affected by the changes in Implied Volatility (IV).
When IV decreases, Theta will be higher, particularly when it is nearing to expiration.
On the other hand, when IV increases, Theta would be lower.

Why is it so?
As previously discussed in Part 1, the level of Time Value of an option could basically be associated with the level of uncertainty as to whether or not an option can finish ITM.
The more uncertain as to whether an option can or cannot finish ITM before or at expiration, the higher the time value will be.

When Implied Volatility decreases and the option is nearing to expiration, such uncertainty will be lower.
Since Theta is the rate of time decay, when IV decreases, Theta will be higher (i.e. the rate of time value decrease due to the passage of time will be faster).
This is because higher Theta would consequently result in lower time value, which reflects the lower level of uncertainty due to lower Implied Volatility.
And this is particularly so when the expiration is nearing, because the underlying stock price will have lesser time to move, and therefore have even lower probability to finish ITM (i.e. even lower level of uncertainty).

Related Topics:
* FREE Trading Educational Videos You Should NOT Miss
* Options Trading Basic � Part 1
* Options Trading Basic � Part 2
* Understanding Implied Volatility (IV)
* Option Greeks

Read more »

Option�s TIME VALUE � Putting It Together � Part 3: Main Factors � Implied Volatility & Time to Expiration

Go back to Part 2: Main Factors � 1) Degree of Options Moneyness

2) Implied Volatility (IV)
The higher the IV, the higher the option�s time value.

Why is it so?
Because higher IV reflects a greater expected fluctuation (in either direction) of the underlying stock price (e.g. due to earnings announcement is nearing, pending for FDA approvals, or some other important event / news, which is expected to move the stock price drastically).
Therefore, when IV is higher, the options would be more uncertain as to whether or not the options can finish ITM. This explains the higher time value.

3) Time Remaining to Expiration
The longer the time remaining to expiration, the higher the option�s time value.
Hence, all other things being equal, an option with more days to expiration will have more time value than an option with fewer days to expiration.

Why is it so?
Because the longer the time remaining to expiration, the underlying stock price would have more time to fluctuate, resulting in more uncertainty as to whether or not the options can finish ITM, and therefore the higher the time value.

As the option is approaching expiration, assuming all other things constant, the level of uncertainty will decrease, because the underlying stock price will have lesser time to move. Hence, the time value will decrease as the time to expiration gets shorter.

In general, for both Calls & Puts, as expiration is nearing, the Time Value component of an option price decreases or �erodes�. This is often called �Time Decay�.

Continue to Part 4: Behavior of Time Value

Related Topics:
* FREE Trading Educational Videos You Should NOT Miss
* Options Trading Basic � Part 1
* Options Trading Basic � Part 2
* Understanding Implied Volatility (IV)
* Option Greeks

Read more »

Option�s TIME VALUE � Putting It Together � Part 2: Main Factors � Degree of Options Moneyness

Go back to Part 1: Understanding What Time Value is.

MAIN FACTORS THAT AFFECT OPTION'S TIME VALUE
As discussed in the previous post, Time Value of an option will be mainly affected by:
1) Degree of Options Moneyness
2) Implied Volatility (IV)
3) Time Remaining to Expiration

Let�s see how all these factors affecting Time Value can be explained by �the level of uncertainty as to whether or not an option can finish ITM�.

1) Degree of Options Moneyness
As discussed in this post, Options Moneyness describes the relationship between an option�s Strike Price with stock price (i.e. where the Option�s Strike Price is in relation to the current stock price).

The farther the Option�s Strike Price to current stock price, the lower the time value will be.
Therefore, since for ATM options, the option�s Strike Price is the same as the current stock price, ATM options would consequently have the highest time value.
The time value will gradually decline as it moves to deeper ITM and deeper OTM options (like inverted-U curve), because the deeper ITM or OTM an option, the farther its Strike Price from the current stock price.

Why is it so?
Because ATM or near ATM options would have a higher uncertainty level as to whether or not the options can finish ITM, as compared to OTM & ITM options do.
This uncertainty level can be explained by the how far an option�s strike price from the current stock price (i.e. degree of Options Moneyness).

For OTM options:
The farther the option�s Strike Price from current stock price is (i.e. deeper OTM options), the more likely / higher probability that the OTM option cannot become ITM before or at expiration.
Since it has �higher probability� that the deeper OTM options cannot finish ITM (or �lower probability� that the deeper OTM options can finish ITM), that means the options would have �lower level of uncertainty� as to whether or not it can finish ITM.
This explains why deeper OTM options, the lower the option�s time value.

For ITM options:
The farther the option�s Strike Price from current stock price is (i.e. deeper ITM options), the more likely / high probability that the ITM option can become ITM before or at expiration.
Since it has �higher probability� that the deeper ITM options can finish ITM (or �lower probability� that the deeper ITM options cannot finish ITM), that means the options would have �lower level of uncertainty� as to whether or not it can finish ITM.
This explains why deeper ITM options, the lower the option�s time value.

For ATM or near ATM options:
As the option�s Strike Price is equal to or near current stock price, it is still very uncertain if the option can or cannot become ITM before or at expiration.
In other words, ATM or near ATM options have �higher level of uncertainty� as to whether the options can or cannot finish ITM. As a result, their time value will be higher.



Continue to Part 3: Main Factors � Implied Volatility & Time to Expiration.

Related Topics:
* FREE Trading Educational Videos You Should NOT Miss
* Options Trading Basic � Part 1
* Options Trading Basic � Part 2
* Understanding Implied Volatility (IV)
* Option Greeks

Read more »

Option�s TIME VALUE � Putting It Together � Part 1: Understanding What It Is

As mentioned in �Option Price Components�, option price or premium consists of:

For ITM Option:
Option Price = Intrinsic Value + Time Value

For ATM and OTM Options:
Option Price = Time Value

Whereas:

Intrinsic Value of ITM CALL Option:
Intrinsic Value = Current Stock Price � Strike Price.

Intrinsic Value of ITM PUT Option:
Intrinsic Value = Strike Price � Current Stock Price.

As can be seen in the above formula, it is only ITM options that have Intrinsic Value component, whose value is simply the difference between option�s strike price and current stock price.
Whereas for ATM & OTM options, Time Value is the only component of the options� price / premium.

What Is Option�s Time Value?

As mentioned in the previous post - More Understanding about Options Time Value:

Time value can be viewed as �the price that people are willing to pay for the chance / uncertainty as to whether or not an option will finish In-The-Money (ITM)�.
The more uncertain, the higher the time value will be.

In other words, the level of Time Value of an option could basically be associated with the level of uncertainty as to whether or not an option can finish ITM.
The more uncertain as to whether an option can or cannot finish ITM before or at expiration, the higher the time value will be.
When it is more certain that an option can or cannot finish ITM, the time value will be lower.
In other words, when an option has �higher or lower probability� that it can or cannot become ITM before or at expiration, that means the �level of uncertainty� will be lower.
So, it is the level of uncertainty that matters, not whether it has higher or lower probability to finish ITM or not finish ITM.

In the next post, we�ll discuss further with more elaboration and examples about how this �level of uncertainty� could explain option�s time value.

Continue to Part 2: Main Factors that Affect Option�s Time Value.

Related Topics:
* FREE Trading Educational Videos You Should NOT Miss
* Options Trading Basic � Part 1
* Options Trading Basic � Part 2
* Understanding Implied Volatility (IV)
* Option Greeks

Read more »

Main Factors that Affect Option�s TIME VALUE

As mentioned in �Option Price Components�, option price or premium consists of:

For ITM Option:
Option Price = Intrinsic Value + Time Value

For ATM and OTM Options:
Option Price = Time Value

Whereas:

Intrinsic Value of ITM CALL Option:
Intrinsic Value = Current Stock Price � Strike Price.

Intrinsic Value of ITM PUT Option:
Intrinsic Value = Strike Price � Current Stock Price.

As you can see from the above formula, Intrinsic Value of an option is very straightforward.
It�s simply the difference between option�s strike price and current stock price.
Time Value component of an option is the one that make an option very complicated to understand.

Time Value of an option would be mainly affected by:

1) Degree of Options Moneyness
As discussed in this post, Options Moneyness describes the relationship between an option�s Strike Price with stock price (i.e. where the Option�s Strike Price is in relation to the current stock price).

The farther the option�s Strike Price to current stock price, the lower the time value will be.
Therefore, since for ATM options, the option�s Strike Price is the same as the current stock price, ATM options would consequently have the highest time value.
The time value will gradually decline as it moves to deeper ITM and deeper OTM options (like inverted-U curve), because the deeper ITM or OTM an option, the farther its Strike Price from the current stock price.

2) Implied Volatility (IV)
The higher the IV, the higher the option�s time value.

3) Time Remaining to Expiration
The longer the time remaining to expiration, the higher the option�s time value.
All other things being equal, an option with more days to expiration will have more time value than an option with fewer days to expiration.

Hence, Implied Volatility (IV) is not the only one that influences an option�s time value. That�s why although, for instance, IV of an option is very much higher than the other options, it does not mean that its premium will be higher in terms of dollar value. There are other factors affecting their overall premium.

Just remember that whether an option is considered �cheap� or �expensive�, it is not based on the absolute dollar value of the option, but instead based on its IV.
When the IV is relatively high, that means the option is considered �expensive�.
On the other hand, when the IV is relatively low, the option is considered �cheap�.
(Please see this post � How To Determine If An Option Is Cheap (Underpriced) Or Expensive (Overpriced) � for further discussion).

However, the overall option price / premium in absolute dollar value will be determined by other factors as discussed above.
Therefore, it�s possible that an option is low in terms of dollar value, but it�s considered �expensive� due to relatively high IV.
On the other hand, an option can be high in terms of dollar value, but it�s considered �cheap� due to relatively low IV.

Related Topics:
* FREE Trading Educational Videos You Should Not Miss
* Options Trading Basic � Part 1
* Options Trading Basic � Part 2
* Understanding Implied Volatility (IV)
* Option Greeks
* Learning Charts Patterns

Read more »

More Understanding about Options Time Value

As we know, an option�s price comprises of 2 components: Intrinsic Value + Time Value.
Assuming all other things remain constant (i.e. no changes in the underlying stock price and volatility), the time-value component of an option is affected by 2 variables (both for Call & Put Options):

* Time remaining until expiration.
The longer the time to expiration, the more time value the option will have.

* The closeness of the option Strike Price to the money.
At-The-Money (ATM) options have the maximum level of time value, and the time value decreases as it moves to deeper In-The-Money Options (ITM) and deeper Out-Of-The-Money (OTM) options (like inverted-U curve).
Time value is at its highest level when an option is ATM because the potential for Intrinsic Value to begin to increase is the greatest at this point.

Note:
ATM options have the highest level of time value. Time value decreases as it moves to deeper ITM or OTM options (like inverted-U curve).
This can be understood better if we see the time value as the price that people are willing to pay for the chance / uncertainty as to whether or not an option will finish ITM.
The more uncertain, the higher the time value will be.
An option that is far OTM has almost no chance of finishing ITM. As such, it will not command a high time value.
An option that is already deep ITM is almost certain that it will finish ITM, hence time value is smaller.
But ATM or near ATM options have more uncertainty as to whether or not the options will finish ITM, and therefore these options have a higher time value.



In addition, we know that for both Calls & Puts, the time value component of an option price decreases as expiration is nearing, and the decrease rate is accelerating as it is getting closer to expiration, particularly for At-The-Money (ATM) options. This means that the amount of time value disappearing from the option price per day gets bigger with each passing day.

Please note here that Time Value decrease at an accelerating rate as expiration nears is true only for ATM option. This is because for ATM option, Theta increases as an option get closer to expiration (Please refer back to the previous post here).
For ATM option, time value decreases sharply particularly the last 30 days before expiration.

Nevertheless, for both ITM & OTM options, Theta decreases as an option is approaching expiration. Hence, for both ITM & OTM options, Time Value actually decreases at a decelerating rate as expiration nears.

Sigma Options had a good article about this in �What You Didn�t Know About Time Decay�.

Related Articles:
* In-The-Money, At-The-Money, and Out-Of-The-Money Options
* Option Price Components
* Options Pricing: How Is Option Priced?
* Option Greeks

Read more »

Option Greeks: THETA

Theta is a measure of the rate of decline of option�s time-value resulting from the passage of time (time decay).
Theta provides an estimate of the dollar amount that an option price will lose each day due to the passage of time and there is no move in either the stock price or volatility.

Theta and the position in the market:
� Long calls and long puts always have negative theta.
� Short calls and short puts always have positive theta.
� Stock has zero theta � its value is not eroded by time.

Positive theta means that the option value will increase as the time passes, while negative theta means the option value will fall as the time passes.

Therefore, it makes sense that long options have negative theta and short options have positive theta. If options are continuously losing their time value as days pass, a long option position will lose money because of theta, whereas a short option position will make money because of theta.

But theta does not reduce an option�s value in an even rate. Theta has much more impact on an option that is nearing expiration than an option that is still far away from expiration.
The further is an option from its expiration date, the smaller the time decay (theta) will be for the option.
This implies that if you want to buy options (Calls or Puts), it is advantageous to buy longer term contracts to minimize the time decay effect.
However, if you want a strategy to take advantage of time decay, then you should sell the shorter term options, so that the loss in time value would happen quickly.

Example:
The price of ABC May 50 Call with 25 days to expiration is $3. Its theta is -0.10. The price of ABC Jul 50 Call with 85 days to expiration is $4.8, and the theta is -0.03. When one day passes and there is no change in ABC stock price as well as the implied volatility of either options, the value of ABC May 50 Call will decrease by $0.10 to $2.9, and the value of ABC Jul 50 Call will drop by $0.03 to $4.77.

Theta of ATM, ITM & OTM Option
Theta is typically highest for ATM options, and is progressively lower as options are ITM and OTM.
This makes sense because ATM options have the highest time value component, so they have more time value to lose over time than an ITM or OTM option.

The Effect of Time Remaining to Expiration on Theta

For ATM option, Theta increases as an option get closer to the expiration date.

In contrast, for ITM & OTM options, Theta decreases as an option is approaching expiration. The above effects are particularly observed in the last few weeks (about 30 days) before expiration.

The Impact of Implied Volatility (IV) on Theta
When Implied Volatility (IV) decreases, Theta will be lower, especially when it is approaching expiration.
On the other hand, when IV increases, Theta would be higher.

Comparing more volatile stocks (higher volatility stocks) vs. less volatile stocks (lower volatility stocks), the theta of more volatile stocks is higher than that of less volatile stocks. This is because the time value portion of more volatile stocks is higher, and therefore they have more to lose per day as time passes.

To read about other Option Greek, go to: Option Greeks.

Related Posts:
* More Understanding about Options Time Value
* OPTION PRICING: How Is Option Priced?
* Difference Between Option�s Volume and Open Interest
* Understanding Implied Volatility (IV)
* Options Trading Basic � Part 2
* FREE Trading Videos from Famous Trading Gurus

Read more »

OPTION GREEKS - Introduction

The "Greeks" in options trading is known as a way to measure the sensitivity of an option price to changes in its parameters. The Greeks can help option traders to better understand the potential risk and reward of an option position. However, it is important to note that the numbers given for each of the Greeks are strictly theoretical, as they are only projected based on mathematical models.

In addition, the Greeks numbers also change as the conditions (like actual stock price, volatility) change. How the various Greeks move as conditions change depends on how far the strike price is from the actual price of the stock (Deep ITM or ATM or deep OTM) and how much time is left until expiration.

Options Greeks numbers are usually presented in Greeks tables. The numbers shown in the Greeks table are normally in decimals that indicate the change per share. To normalize the Greeks for dollars, just multiply them by 100 (the number of shares per option contract).

Samples of Greeks Tables for Call Options:













Samples of Greeks Tables for Put Options:

The following are the major Greeks in options trading:

1. Delta
Delta is a measure of the change in the option price resulting from a change in the underlying stock price.

2. Gamma
Gamma is a measure the rate of change of delta due to a one-point change in the price of the underlying stock.

3. Theta
Theta is a measure of the rate of decline of option�s time-value resulting from the passage of time (TIME DECAY).

4. Vega
Vega is a measure the sensitivity of an option�s price to changes in Implied Volatility (IV).

5. Rho
Rho is a measure of the change in an option's price due to a change in interest rate.

We�ll discus each of the Greeks further in the next posts.

To read further about each of the Option Greeks, go to: Option Greeks.

Related Posts:
* OPTION PRICING: How Is Option Priced?
* Understanding IMPLIED VOLATILITY (IV)
* Difference Between Option�s Volume and Open Interest
* FREE Trading Videos from Famous Trading Gurus

Read more »

OPTION PRICING: How Is Option Priced? (Part 2)

In Part 1, we know that there are 6 factors that affect option's price: option�s strike price, stock price, time to expiration, implied volatility, interest rate, and dividend.

Nevertheless, the impact of interest rate and dividend are often considered negligible as compared to the other factors. Most of the time, for each level of strike price, an option�s price will move due to the movement of underlying stock price, volatility and time.

The Black-Scholes formula can be used to calculate the theoretical value of an option based on the above factors.

What is the use of knowing an option�s theoretical value? By knowing the option�s theoretical value, option traders can compare the prevailing option price in the exchange against this theoretical value to determine if a particular option contract is over or under valued, hence helping them in their option trading decision.

Options Calculator / Pricer is normally used to help compute the theoretical value of option price.

THE IMPACTS ON OPTION�S POSITION

Since option�s buyers (long position) will profit when the option price rises after they buy (Buy Low, Sell High), whereas the seller (short position) will profit when the option price falls after they sell (Sell High, Buy Low), the impact of the above factors will also be different.

The following table shows how the major factors (stock price, time to expiration, implied volatility) affect an option�s position.

Example:

Increase in Implied Volatility (IV) would increase option�s price (both calls & puts), assuming other factors unchanged. Hence, this will be favorable for option buyers who will gain if the option price increases (buy low, sell high), but unfavorable for option sellers that will profit if the option price drops (sell high, buy low).

Related Topics:
* Options Trading Basic � Part 1
* Options Trading Basic � Part 2
* Understanding Implied Volatility (IV)
* Option Greeks
* FREE Trading Educational Videos You Should Not Miss

Read more »

OPTION PRICING: How Is Option Priced? (Part 1)

Option price does not always move in conjunction with the price of the underlying stock. As such, it is important to understand what factors contribute to the movement in the option price, and what effect they have.
There are 6 factors that affect option price:

1. OPTION STRIKE PRICE
Strike price determines whether an option is In-The-Money, At-The-Money, and Out-Of-The-Money.
The more deeply In-The-Money (ITM), the higher the option price will be, as it carries more intrinsic value.
The further an options is Out-Of-The-Money (OTM), the lower the option price will be.

2. CURRENT STOCK PRICE
This factor has opposite impact on call and put (assuming all other factors kept constant):
When stock price increase, Call premium will increase and Put premium would decrease.
When stock price decrease, Call premium will decrease and Put premium would increase.

3. TIME (NUMBER OF DAYS) REMAINING UNTIL EXPIRATION
This factor affects the Time Value component of an option price. All other things being equal, an option with more days to expiration will have more Time Value component than an option with fewer days to expiration.
In general, for both Calls & Puts, the Time Value component of an option price decreases or �erodes� as expiration is nearing (often called �Time Decay�). And the Time Value component would decrease at an accelerating rate as it is getting closer to expiration, particularly for At-The-Money (ATM) option.
Due to time decay effect, even though a stock price, say, just remains constant till expiration, an Out-Of-The-Money (OTM) option price which contains only time value will decrease over time and then expire worthless. Therefore, time is the enemy of options buyers, but a friend for options sellers.

4. IMPLIED VOLATILITY (IV)
Volatility is a measure of risk / uncertainty of the underlying stock price of an option. It reflects the tendency of the underlying stock price of an option to fluctuate either up or down. Volatility can only suggest the magnitude to the fluctuation, not the direction of the movement of the price.
Implied Volatility (IV) here is an estimate of future volatility. Since it is only an estimate, it is the most subjective and probably the most difficult factor to quantify. Nevertheless, IV can have a significant impact on the time value component of an option's premium.
Higher Implied Volatility reflects a greater expected fluctuation (in either direction) of the underlying stock price, and as such it is more likely that the underlying stock will move in your favor.
As a result, the higher the Implied Volatility of the underlying stock, the more expensive its options (both Calls & Puts) will be, because there is a greater possibility that the options will end up in your favor profitably.

5. INTEREST RATE
The impact of interest rate on option�s price has something to do with the �carrying cost� of stocks. When you are bullish on a certain stock, it is much cheaper to buy Call option than the stock itself. The interest cost should you buy the stocks is built into the Call option�s value.
In this case, all other things kept constant, an increase in interest rates will lead to an increase in Call premiums and a decrease in Put premiums.
However, in reality, all other things rarely remain constant. An increase in interest rates will generally result in a drop in stock prices, and this impact would often overwhelm the effect of interest rate on option price. Therefore, the impact of interest rate on option�s price is not certain, depending on the combined effects of the change in stock price (due to interest rate changes) and the �carrying cost� effect.

6. DIVIDEND
A stock price is expected to drop by the amount of the dividend on the ex-dividend date. Hence, high cash dividends imply lower call premiums and higher put premiums.

Continue to Part 2

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Option Price Components (Part 2)

Go back to �Part 1�

EXAMPLES FOR INTRINSIC VALUE & TIME VALUE CALCULATION:

For Call Option:
Current stock price = $30.
The price of Call option with Strike Price of $20 = $12
This call option is In-The-Money (ITM) option because Strike Price ($20) < Stock Price ($30).
Intrinsic Value = Stock Price � Strike Price = $30 � $20 = $10.
Time value = Option price � Intrinsic Value (if any) = $12 - $10 = $2
Here, the call option is said to be In-The-Money with intrinsic value of $10, as it allows the call option buyer to immediately buy a $30 stock at $20 the moment he bought it.

Current stock price = $30.
The price of Call option with Strike Price of $40 = $0.5
This call option is Out-Of-The-Money (OTM) option because Strike Price ($40) > Stock Price ($30).
Intrinsic Value = 0 (No intrinsic value for OTM option)
Time value = Option price � Intrinsic Value (if any) = $0.5
Here, the call option is called Out-Of-The-Money, as it is better for the call option buyer to buy the stock from the market at $30 than to immediately exercise the option at $40 strike price.


For Put Option:
Current stock price = $30.
The price of Put option with Strike Price of $35 = $6.
This put option is In-The-Money (ITM) option because Strike Price ($35) > Stock Price ($30).
Intrinsic Value = Strike Price � Stock Price = $35 � $30 = $5.
Time value = Option price � Intrinsic Value = $6 - $5 = $1.
Here, the put option is said to be In-The-Money with intrinsic value of $5, as it allows the put option buyer to immediately sell a $30 stock at $35 the moment he bought it.

Current stock price = $30.
The price of Put option with Strike Price of $25 = $0.3.
This put option is Out-Of-The-Money (OTM) option because Strike Price ($25) < Stock Price ($30).
Intrinsic Value = 0 (No intrinsic value for OTM option).
Time value = Option price � Intrinsic Value (if any) = $0.3.
Here, the put option is called Out-Of-The-Money, as it is better for the put option buyer to sell the stock in the market at $30 than to immediately exercise the option at $25 strike price.

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Option Price Components (Part 1)

The price of an option consists of 2 main components:
Intrinsic Value and Time Value (Time value is also known as Extrinsic Value).

OPTION PRICE = INTRINSIC VALUE + TIME VALUE

Intrinsic Value is the value that is already built into the option the moment you bought it. Or in other words, the value by which an option is "in-the-money".
Time Value is the difference between an option�s price and its intrinsic value. As the option nears expiration, the time value erodes and eventually becomes zero.

Only In-the-Money (ITM) option has intrinsic value.
For At-The-Money (ATM) and Out-Of-The-Money (OTM) options, the intrinsic value is zero, therefore the option price comprises of only time value. Therefore:

For ITM Option:
Option Price = Intrinsic Value + Time Value

For ATM and OTM Options:
Option Price = Time Value

HOW TO CALCULATE INTRINSIC VALUE & TIME VALUE:

Intrinsic Value of ITM Call Option:
Intrinsic Value = Current Stock Price � Strike Price.

Intrinsic Value of ITM Put Option:
Intrinsic Value = Strike Price � Current Stock Price.

Time Value of All Options (ITM, ATM, OTM):
Time value = Option price � Intrinsic Value (if any)

As a result, the deeper we move into the money, the higher the option price will be (as it has more intrinsic value). The further we go out of the money, the cheaper the option price would be.
The option prices will change throughout the trading day based on the underlying stock movement, volatility and time.

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