When referring to option pricing, time value is the amount an individual is willing to pay for the uncertainty that an option will complete in-the-money, or ITM. The more of a chance the option will not finish ITM, the higher an option's time value. However, if the chance of the option finishing ITM is almost certain, and even expected, the time value will be much lower.
There are three specific factors that can affect this level of uncertainty, and therefore affect both the time value and the option pricing.
Degree of Option MoneynessIV, or Implied VolatilityThe Amount of Time Till Expiration
In the following we will discuss exactly how these three factors affect time value and option pricing.
3 Factors That Affect Time Value
Because time value is one of the main factors that influences the price of options, the factors that affect this value can directly affect the pricing of your option.
Degree of Options Moneyness- Options Moneyness is a term that describes the link between the option's strike price and the current price of a stock. If the prices are the same and at-the-money, or ATM, the value will be higher. If the strike price of the option declines and move toward in-the-money (ITM) or out-of-the-money (OTM) the chance of it finishing ITM is much higher, so the value will be lower. Remember, the value of time is always higher for options when they are ATM, because there generally is more of a chance they will have the time and ability necessary to change when they are in this state, unlike when they are OTM or ITM.
Implied Volatility- When the implied volatility of an option, or IV, is low, the time value of the option will be much lower. The same logic would be used it if it was higher. Why is this, though? When IV is high, it fluctuates much more, in either direction, than it does when it is low. This means we expect there to be more fluctuations and more dramatic changes to the underlying price of the option. For this reason, we can't be certain if a high IV will allow the option to complete ITM, so it has a higher time value.
The Amount of Time Until Expiration- If there is a significant amount of time remaining until the option's expiration, the time value of that option will be much higher. If the option's expiration date is close, however, the value will be lower. This is because the longer period of time allows the price of the option to fluctuate more, giving it a greater uncertainty it will finish ITM. As the option approaches its expiration date, however, it has less time for change, and unexpected occurrences aren't as likely. This means the value sill most likely decrease.
Time value is one of the main factors that drives option pricing, so it makes sense that the factors that drive the value can directly affect the price of an option. If you are trying to determine the best option price, make sure to look at the time value of the option.
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