What is time value?

Time value is a very important concept to understand if you are going to trade options. It will help you to understand how your option is priced and even how to avoid watching the value of your option going down while the price of the stock goes up.

To examine how time value works, let us look at an example of an option. Stock XYZ is trading at $69. The $65 call is trading at $6. This option gives the holder the right to buy the stock at $69 by a certain date.

If you subtract the stock price from the strike price you get $4. ($69-$65). This $4 is called the intrinsic value of the stock. The remaining $2 is time value.

Time value will greatly influence the profitability of your option. As time gets closer to expiration the time value of the option goes down. So it is possible to buy an option where the stock’s price goes up but the options price goes down.

To make money on an option the stock price has to go up faster than the time value of the option is decaying. That being said there are a few steps you can take to offset the decay of time value.

1. The first thing you could do is buy more time than you think you need. Most of the time value will decay in the last 30 days of the option. If you buy an option set to expire in 3 or 4 months time value will decay extremely slowly and as a result you do not have to see the stock move as fast as you would if you had just bought an option contract that is set to expire in 1 months time.

The side benefit to buying more time is that you have more time to wait for a stock to make its move.

2. The second thing you can do is buy ITM (in the money) options. The further ITM you buy the less percentage of that option is time value. An option $10 in the money has more intrinsic value then an option $5 ITM. An option $5 out of the money (OTM) is 100% time value and has no intrinsic value whatsoever.

The side benefit to ITM options is that they tend to be influenced by the stock a lot more than OTM options. But they also cost more and give you a lower percentage return on big moves then OTM options, so there is a tradeoff here.

In short time value is just something you are going to have to get used to if you want to be doing a lot of stock option trading. It is worth your effort to try to reduce it as much as you can in order to increase your overall returns.