Term time value

What Is Term Time Value?

Term time value, often referred to as time value, represents the portion of an option premium that exceeds its intrinsic value. It quantifies the value an options contract holds due to the remaining time until its expiration date and the expected volatility of the underlying asset's price. This concept is central to derivatives valuation and reflects the potential for an option to gain intrinsic value before it expires. The more time an option has until expiration and the higher the expected volatility of the underlying asset, the greater its term time value.

History and Origin

The concept of valuing options has roots dating back centuries, with early forms of option-like instruments traded in ancient times, such as the olive press speculation by Thales of Miletus. However, the modern era of organized options trading began with the establishment of the Chicago Board Options Exchange (CBOE) in 1973. This marked a pivotal shift from over-the-counter, bilaterally negotiated options to standardized, exchange-traded contracts, facilitating greater liquidity and accessibility.⁴

The formalization of options pricing gained significant traction with the publication of the Black-Scholes model in 1973 by Fischer Black and Myron Scholes. This groundbreaking mathematical model provided a framework for consistently pricing European-style options, factoring in variables like the underlying asset's price, the option's strike price, time to expiration, interest rates, and volatility. Robert C. Merton's independent and concurrent work, along with his extensions to the model, also significantly contributed to its widespread adoption and understanding.³ The Black-Scholes model fundamentally changed how market participants understood and calculated term time value, moving it from an intuitive guess to a quantifiable component of an option's price.

Key Takeaways

Term time value is the portion of an option's premium that accounts for the remaining time until expiration and the underlying asset's expected volatility.
It is calculated as the option's market price minus its intrinsic value.
Term time value decays over time, a phenomenon known as time decay, accelerating as the expiration date approaches.
Options that are out-of-the-money or at-the-money consist entirely of term time value.
Higher expected volatility and longer time to expiration generally lead to greater term time value.

Formula and Calculation

The term time value of an option can be calculated by subtracting its intrinsic value from its total premium:

\text{Term Time Value} = \text{Option Premium} - \text{Intrinsic Value}

For example, consider a call option with a strike price of $50 trading at $3, while the underlying stock is currently at $52.

First, calculate the intrinsic value:
For a call option, intrinsic value = Max(0, Current Stock Price - Strike Price)
Intrinsic Value = Max(0, $52 - $50) = $2

Then, calculate the term time value:
Term Time Value = Option Premium - Intrinsic Value
Term Time Value = $3 - $2 = $1

This $1 represents the value attributed to factors beyond the immediate profitability of exercising the option, primarily the time remaining and potential for price movement.

Interpreting the Term Time Value

The term time value provides insight into the market's expectation of future price movements and the perceived risk associated with an option. A higher term time value suggests that the market anticipates significant price swings in the underlying asset before the expiration date, or that there is still considerable time for the option to move into or deeper into the money. Conversely, a low term time value indicates that the option is close to expiration, or that the market expects minimal price movement.

For out-of-the-money and at-the-money options, the entire option premium is composed of term time value, as they have no intrinsic value. As an option approaches expiration, its term time value diminishes, eventually reaching zero at expiration. This process, known as time decay, affects options differently based on their moneyness and the proximity to expiration, typically accelerating in the final weeks or days.

Hypothetical Example

Imagine an investor considers purchasing a call option on Company XYZ stock. The stock is currently trading at $100. The investor is looking at a call option with a strike price of $105, expiring in three months, and trading for a premium of $3.

Calculate Intrinsic Value: Since the stock price ($100) is below the strike price ($105), this option is out-of-the-money. Therefore, its intrinsic value is $0.
Calculate Term Time Value:
Term Time Value = Option Premium - Intrinsic Value
Term Time Value = $3 - $0 = $3

In this scenario, the entire $3 premium paid for the option is its term time value. This indicates that the investor is paying solely for the potential for the stock price to rise above $105 before expiration, plus a cushion. If the stock were to remain at $100 until expiration, the option would expire worthless, and the investor would lose the entire $3 premium, which was its term time value.

Practical Applications

Term time value is a critical component in various aspects of financial markets, particularly in options trading and risk management.

Valuation Models: It is a key input and output in sophisticated options pricing models like the Black-Scholes model, which mathematically estimates an option's theoretical value.
Trading Strategies: Traders use their understanding of term time value to select appropriate strategies. For instance, options sellers (writers) often seek to profit from the decay of term time value, especially on options they expect to expire worthless. Conversely, options buyers need to consider how quickly term time value might erode, particularly with shorter-dated contracts.
Impact of Interest Rates: Changes in interest rates can influence term time value. Generally, higher interest rates increase the term time value of call options and decrease that of put options, and vice versa.² This effect is captured by "rho," one of the options "Greeks."
Hedging and Speculation: Investors involved in hedging use options to mitigate risk, and understanding term time value helps them assess the cost of this protection. Speculators, on the other hand, might purchase options with significant term time value, betting on a large price movement in the underlying asset.

Limitations and Criticisms

While fundamental to options valuation, the concept and measurement of term time value have limitations, often stemming from the assumptions of the models used to calculate it.

Model Assumptions: The most prominent options pricing models, such as the Black-Scholes model, rely on certain assumptions that may not hold true in real-world markets. For example, the assumption of constant volatility is a significant critique, as volatility is rarely constant and can fluctuate dramatically.¹ Other assumptions include no transaction costs, continuous trading, and constant risk-free interest rates.
Implied vs. Historical Volatility: Calculating term time value requires an estimate of future volatility, which can be derived from historical data or implied from current option prices. Discrepancies between these two measures can lead to differing views on an option's fair term time value.
Market Inefficiencies: While models provide a theoretical term time value, actual market prices can deviate due to supply and demand, market sentiment, and other short-term inefficiencies. This can create opportunities for traders but also introduces complexity.
Complexity for Beginners: For novice investors, fully grasping how all factors (time, volatility, interest rates, dividends) interact to determine term time value can be challenging, leading to mispricing or misunderstanding the risks involved in speculation or risk management strategies.

Term Time Value vs. Intrinsic Value

Term time value and intrinsic value are the two primary components that make up an option's total option premium. While both contribute to an option's price, they represent different aspects of its worth.

Intrinsic value is the immediate profit an option holder would realize if they exercised the option immediately. For a call option, it is the amount by which the underlying asset's price exceeds the strike price. For a put option, it is the amount by which the strike price exceeds the underlying asset's price. An option must be "in-the-money" to have intrinsic value; otherwise, its intrinsic value is zero.

In contrast, term time value (or time value) is the portion of the premium attributed to the possibility that the option will gain intrinsic value before its expiration date. It reflects the potential for future price movements and the remaining duration of the contract. Unlike intrinsic value, which can only be zero or positive, term time value is always positive for options with time remaining until expiration. As the option approaches its expiration, its term time value diminishes due to time decay, eventually reaching zero at expiration, regardless of whether the option is in-the-money, at-the-money, or out-of-the-money.

FAQs

What causes term time value to decrease?

Term time value decreases primarily due to time decay. As an option's expiration date approaches, there is less time for the underlying asset's price to move favorably, reducing the option's potential to gain intrinsic value. This decay accelerates as the option gets closer to expiration. Additionally, a decrease in the volatility of the underlying asset can also cause term time value to decrease, as it implies less chance of significant price movements.

Can term time value be negative?

No, term time value cannot be negative. It represents the value beyond the immediate profit (intrinsic value) that an option holds due to time and expected volatility. Since the lowest an option's premium can theoretically go is its intrinsic value (assuming active markets and no arbitrage), the term time value component, by definition, must be zero or positive.

How do traders use term time value?

Traders use term time value in various ways. Buyers of options pay for term time value, hoping that favorable price movements or increased volatility will cause the option's value to increase more than its decay. Sellers of options (writers) aim to profit from the erosion of term time value as the expiration date nears, especially for out-of-the-money options. Understanding term time value is crucial for assessing risk and potential profit in options trading strategies.

Does term time value impact both call and put options?

Yes, term time value impacts both call options and put options. For both types of options, the longer the time until expiration and the higher the expected volatility of the underlying asset, the greater their respective term time values will be. The way intrinsic value is calculated differs between calls and puts, but the concept of term time value as the premium component beyond intrinsic value applies universally to both.