Options Trading
Options trading, whether buying or selling, involves a time component. The date at which the option expires and is no longer valid, dictates much of the value held by an option. As an option moves closer to expiration, the value of the option will diminish - this concept is known as ‘Time Value’.
Time Value can be broken down into two distinct parts: Intrinsic Value, and Extrinsic Value. The Intrinsic Value is the cost of the underlying, while the Extrinsic Value is the extra: the ‘time’ component. Time Value is highly directional in nature, meaning that, as a trader, the further out of the money an option is placed, the more likely the option is to expire worthless. Conversely, in-the-money options (options which are likely to be profitable) will have a higher Time Value since the expiration date is further away.
Time Value also affects the price of the option. Time Value of an option goes down with time, as the option approaches its expiration. This is due to the time value component of an option’s price eroding, even if the stock price does not change. Selling an option, before the expiration date is one way to capture the Time Value decay rate.
The amount and rate of Time Value decay is further impacted by a few factors, including but not limited to the level of implied volatility, the amount of time remaining and the price of the underlying asset.
Knowing how and when to use Time Value can be a powerful tool when it comes to trading stock options. In order to get the most out of an option, one must understand how to use the passage of time in their favor. As many experienced traders know, Time Value tends to be the difference between a winning trade, and a loser.
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