Time runs only in a negative direction, bringing the option premium down with each passing day
Options are assets that waste away with time, i.e., with every passing day, the value of the premium decreases. Though the premium is made up of "intrinsic" and "time" value, it's the time decay of an option position that can make or mar profits.
The movement of the share price has the possibility of moving an option from an in-the-money (profitable) position to out-of-the-money (unprofitable) one for a buyer. Market-makers and other writers of options require an "insurance premium" to cover the unlimited risk they undertake to ensure the buyer has a limited loss situation. This additional premium charged to the holder is sometimes called time value.
Time value or time decay can be seen not only as one moves from 30 to 90 day contracts, but also as one moves from an out-of-the-money (OTM) strike to an in-the-money (ITM) position or vice versa. The table below carries the premiums for the September and November Satyam calls. The time value can be observed if one considers any strike for the November and September calls.
For example, the markets are pricing 220 calls of November (90-day contract) higher at Rs 26.8 compared with the 220 September call (30-day contract) at Rs 21.05. The increase is due to the higher probability of the November option expiring profitably owing to the longer time frame and possible movement of the underlying price in favour of the option holder.
OTM - ATM - ITM are the notations given to options based on such anticipated profit, or in other words, the intrinsic value of an option. If a trader has bought an option at a lower strike price, his position has an intrinsic value. For example, the 220 September Call gives the trader the right to buy the underlying at Rs 220 when the market price for the same is Rs 239. This gives the option position an inherent value of Rs 19.
Time value is greatest when an option is ATM (the exercise price is very close to underlying security price) and decreases as the option becomes either in or out-of-the-money. This is due to the uncertainty of whether the option will move ITM or OTM.
The more an option is in-the-money, the lower the probability of it moving into a more profitable situation. The more an option is OTM the greater the probability of it to expire worthless. However, when an option is at-the-money, it is possible for it to move either in or out of-the-money. The extra time value is to compensate the writer of the option for this possibility.
The time value element of September and November Satyam call premiums are given. The graph shows that when an option is ATM, the time value element of its premium is at its greatest. As we have already stated, this is due to the uncertainty of whether the option will move ITM or OTM.
To wrap up, time runs only in one direction and that is negative, bringing the option premium down with each passing day. This underlines the importance of a timing strategy for the option trader.
(The author works for the derivatives training wing at the BSE)
