In this blog we look at Time to Expiry as a determinant of Call Option Premium.
Prior to expiry, any Premium in excess of Intrinsic Value is called Time Value. Or basically the amount the investor is willing to pay for an Option above its Intrinsic Value.
At Expiry a Call Option is either has value or has no value. This can be expressed as the Call Option being “in the money” ITM or “out of the money” OTM. However while there is time to expiry the end outcome for the Option is less known and Time Value is the value that depicts the level of uncertainty.
If the Call Option is OTM, it means the underlying asset has a market value lower than the Strike Price of the Call Option. Exercising the Call Option to buy the asset would make no sense as the asset can be purchased more cheaply directly. As seen in the wine example in the Understanding Call Options p3.
When valuing the Time Value of the Option we must consider the Volatility of the Underlying Asset, Time Value of Money and Dividends.
Volatility is a measure of the uncertainty, or variability of price of an Options underlying asset. Higher volatility means expected greater price fluctuations (up or down ) in the underlying price levels.
For ITM and “at the money” (ATM) Call Options the Time Value of Money is also a determinant of Call Option Premium.
This means you must consider the return you are receiving by owning the Call Option and excercise Funds verse holding the underlying asset out right.
An asset is now $100 I can buy the Asset out right or can buy a 6 month Call Option to buy that asset for $60.
From previous blogs we know this Options Intrinsic Value is $40. (Asset Value – Strike Price).
However there should be a greater value in the Premium than just The Intrinsic Value, because you have exposure to the Asset and don't have to pay the Strike Price for 6 months. So you are saving a $60 spend for 6 months. Option Premiums should include the value of this cost savings.
If we say interest rates are at 5%, the value of not spending the $60 for 6 months, but rather earning interest on it instead generates a value of $15. ($60 times 5% per annum divided by 2.)
So the Premium of an ITM Call Option with the above scenario would be $55.
Another Consideration when looking at Time Value of a Call Option is to discount its Premium for any event that may lower the value of the underlying asset over the life of the Option.
Typically this occurs when the underlying asset trades ex dividend during the life of the option.
Call Option owners are not entitled to dividends, so if the underlying asset trades ex dividend the value of that asset reduces. As such Premium should be less for Call Options where there is a dividend expected during the life of the Option. The extent of the discount will depend on the Strike Price, ITM Calls having a greater discount than the OTM Calls. As the reduced value of the underlying asset more directly relates to its intrinsic value.
On occasions holders of American style Call Options might decide to Exercise the Option before Expiry to capture the value of the dividend.
In summary, Time to Expiry as a determinant to Call Option Premium has two important aspects. Volatility and Time Value of Money. As expiry nears the impact of both these influences diminish, this is known as option Time Decay. Time Decay occurs because the chance of the Call Option being ITM or OTM becomes more certain, and with increased certainty we see less value placed on time in the Options Premium.
Over the 4 blogs Understanding Call Options we have discussed Defined a Call Option and broken it down into the constituent parts so as to better understand the concepts behind valuing the option and making a decision to exercise or not.
We have discussed Underlying Asset Value, Strike Price, Expiry Date, Premium, Volatility, Time Value of Money, In The Money, Out of The Money, Intrinsic Value, Dividends, American and European Styles and Time Decay.
In future blogs we will investigate practical uses and strategies of buying and selling Call Options within the context of the Australian Option Market.