OPTION BASIC :- UNDERSTANDING THE CONCEPT OF TIME VALUE OF MONEY IN OPTION TRADING...........14.03.2013

OPTION BASIC :- UNDERSTANDING THE CONCEPT OF TIME VALUE OF MONEY IN OPTION TRADING

Money has Time Value. The idea behind Time Value of Money is that a rupee now is worth more than rupee in the future. The relationship between Value of a Rupee today and Value of a Rupee in future is known as ‘Time Value of Money".

In Option Trading Time Value of Money is simply difference on Option Value or Option Premium and Intrinsic Value of the Option. Time Value also known as extrinsic value or instrumental value.

Means, 

Time Value of an Option = Option Premium - Intrinsic Value of an Option

Option Premium :- Option Premium is the premium which the Option Buyer pays to the Option Seller. It is also referred to as the Option Price.

Intrinsic Value of an Option :-

Cleared in the post on 14th Feb 2013  under"Understanding the Concept of Intrinsic Value in Option Trading" . See the post for details.

But For Revision remember this :- 

Intrinsic value of a call option = Spot Price - Strike Price (In case of Buying the Option)
Intrinsic value of a put option = strike price - Spot Price (In Case of Buying the Option) 


"since the longer the option has to go until expiry, the more opportunity there is for the Spot Price to move to a level such that the Option becomes In-the-Money. Generally, the longer the time to expiry, the Higher the Option’s time value. As expiry approaches, the value of an option tends to zero, and the rate of time decay accelerates."


"Means to say that At the beginning or starting of the expiry the Option has maximum Time Value of Money means, whatever the rupee is invested to buy an option now can worth more than rupee in the future. As soon as when the expiry date comes to near the option then then Time Value of Money decreases so the value of an option tends to zero at the end of the expiry."


"Both Calls and Puts have Time Value. An Option that is Out of -the- Money and At -the- Money has only Time Value. Usually the maximum Time Value exists when then Option is At -the- Money. The longer the time to expiration, the greater is an Option's Time Value, all also equal. At expiration doesn't have Time Value." 

Note :- Concept of In -the- Money, Out of -the- Money and At -the- Money have cleared on 14th Feb 2013 post under "UNDERSTANDING THE CONCEPT OF "IN -THE- MONEY OPTION", "OUT OF -THE- MONEY OPTION" & AT -THE- MONEY OPTION" IN OPTION TRADING". See the Post for Details.

But For Memory remember this :-

FOR CALL OPTION IS SAID TO BE IN -THE- MONEY OPTION WHEN SPOT PRICE > STRIKE PRICE MEANS,
POSITIVE CASH FLOW TO THE OPTION HOLDER IN CALL OPTION = SPOT PRICE - STRIKE PRICE

FOR PUT OPTION IS SAID TO BE IN -THE- MONEY OPTION WHEN STRIKE PRICE > SPOT PRICE MEANS,
POSITIVE CASH FLOW TO THE OPTION HOLDER IN PUT OPTION = STRIKE PRICE - SPOT PRICE  

See this graph :-

See the above graph. After the analyzing the above graph it is clear that in the starting of month to expiry Option has maximum Time Value of money but, when the month to expiry is coming the Time Value is decreasing or sloping down. And on the expiry it has become zero value.

So It has cleared that there is no Time Value of Money on the expiry date, so the value or premium of an option becomes zero.