In last week’s article, I began a discussion of option basics. One of the examples I gave was this regarding put options:

“The right to sell QQQ at $87 is valuable, if QQQ is selling for $80. Whoever has that right could buy QQQ on the open market for $80, and then exercise the put option and thereby sell QQQ at $87. That right is worth at least $7 ($87 – $80). If there is some time to go before the option expires, it will be worth more than $7. That is because QQQ could go even lower. In that case, the right to sell it at $87 would be worth even more. Because of that possibility, the option will sell for some amount over $7. In future articles we’ll talk about how much larger that amount can be, and what affects it.”

Today we’ll talk about what affects the amount of time value in an option.

In the case of the $87 put described above, with its underlying asset at $80, we know the value of the put must be at least $7. If it were less than that, here’s what could happen. Say the put was selling for $5. Anyone could pay that $5, plus $80 for a share of QQQ, and then immediately resell QQQ at its $87 market price. This would result in a risk-free profit of $2. If this were the case, then all option traders would want to buy as many of those puts as they could get. They would bid up the price of the puts until the risk-free profit went away, at a price of $7. This $7 difference between the $87 strike price and the $80 stock price is referred to as the intrinsic value of the put.

An option can never be worth less than its intrinsic value. That would enable risk-free profit, and there ain’t no such animal in the option market. But an option can be worth more than its intrinsic value, and almost always will be. Here, if the price of QQQ went even lower, the intrinsic value of the put would go higher. The value of that possibility (of the put gaining even more intrinsic value) is called time value. The amount of time value in any given option is affected by:

  1. The remaining time until expiration. The longer that is, the farther QQQ could move.

  2. The current price of QQQ compared to the $87 strike price. The closer QQQ is to the strike price, the more the time value is worth.

  3. The expected volatility of the QQQ during the life of the option. The faster it is expected to move, the more expensive time value is.

  4. The prevailing risk-free interest rate (in the United States, the short-term US Treasury yield). Higher interest rates increase the value of calls and decrease the value of puts.

  5. Expected dividend payments during the life of the option. These work in the opposite direction from interest rates, decreasing call values and increasing put values.

These five factors are inputs into option pricing models, or formulas, that calculate how much the time value in a given option is worth. Of the five factors, four are bound by rigid rules: Items 4. and 5. (dividend yields and interest rates) are generally constant over the life of the option. Item 1. (time to expiration) declines by a precisely predictable rate. Item 2. (difference between stock price and strike price) has a precisely known effect. That leaves only one factor that can change in sudden and unexpected amounts. That factor is item 3., expected volatility.

Whenever an event occurs that might affect the underlying stock price (whether that effect has happened yet or not), the option market responds by instantly re-evaluating the expected rate of change and pricing that into all of the options for that stock. Not that the option market participants are precisely calculating the effect – they just are willing to pay more or less for the options. Based on what they are now paying, they are implying that they believe that the rate of change is now different. With data on what options are now selling for, we can use the option pricing formula to solve for the amount of expected volatility. The solution to this equation is called implied volatility. We could say that implied volatility is the rate of change that the underlying asset would have to exhibit over the remaining life of the option, for the prices that people are paying for the option to make sense. The notion of implied volatility is a way for us to put a price on “the madness of crowds.” If a change in an option’s price can’t be accounted for in any other way, we call it a change in implied volatility.

Despite its somewhat nebulous nature, implied volatility is a force to be reckoned with. More precisely we could say that people’s expectations of future underlying price movement, which are translated from actual option prices into an implied volatility reading, can have large effects on option prices.

Implied volatility for any given underlying asset can range widely from time to time. The readings for the stock of Apple Computer, for example, have been as low as 19% and as high as 57% in the last year alone. The 19% reading is the current one. As an extreme example, the January 2015 calls (the most distant options we can get) at the $595 strike price are today selling at around $39 per share. If the level of future expectations were to go back to the 57% level, these same options would sell for almost $73 – without any change in the price of the stock at all. Clearly, what people expect to happen to a stock has major ramifications for the value of its options.

Learn to Trade Now


This content is intended to provide educational information only. This information should not be construed as individual or customized legal, tax, financial or investment services. As each individual's situation is unique, a qualified professional should be consulted before making legal, tax, financial and investment decisions. The educational information provided in this article does not comprise any course or a part of any course that may be used as an educational credit for any certification purpose and will not prepare any User to be accredited for any licenses in any industry and will not prepare any User to get a job. Reproduced by permission from OTAcademy.com click here for Terms of Use: https://www.otacademy.com/about/terms

Editors’ Picks

EUR/USD accelerates losses to 1.0930 on stronger Dollar

EUR/USD accelerates losses to 1.0930 on stronger Dollar

The US Dollar's recovery regains extra impulse sending the US Dollar Index to fresh highs and relegating EUR/USD to navigate the area of daily troughs around 1.0930 in the latter part of Friday's session.

EUR/USD News
GBP/USD plummets to four-week lows near 1.2850

GBP/USD plummets to four-week lows near 1.2850

The US Dollar's rebound keep gathering steam and now sends GBP/USD to the area of multi-week lows in the 1.2850 region amid the broad-based pullback in the risk-associated universe.

GBP/USD News
Japanese Yen consolidates near multi-month top against USD as traders await US NFP report

Japanese Yen consolidates near multi-month top against USD as traders await US NFP report

The Japanese Yen bulls retain control amid worries about the economic fallout from Trump’s tariffs. The risk-off mood and relatively hawkish BoJ expectations further lend support to the safe-haven JPY. The USD selling bias keeps USD/JPY close to a multi-month low ahead of the crucial US NFP release.

USD/JPY News

Editors’ Picks

EUR/USD accelerates losses to 1.0930 on stronger Dollar

EUR/USD accelerates losses to 1.0930 on stronger Dollar

The US Dollar's recovery regains extra impulse sending the US Dollar Index to fresh highs and relegating EUR/USD to navigate the area of daily troughs around 1.0930 in the latter part of Friday's session.

EUR/USD News
GBP/USD plummets to four-week lows near 1.2850

GBP/USD plummets to four-week lows near 1.2850

The US Dollar's rebound keep gathering steam and now sends GBP/USD to the area of multi-week lows in the 1.2850 region amid the broad-based pullback in the risk-associated universe.

GBP/USD News
Gold trades on the back foot, flirts with $3,000

Gold trades on the back foot, flirts with $3,000

Gold prices are accelerating their daily decline, steadily approaching the critical $3,000 per troy ounce mark as the Greenback's rebound gains extra momentum and US yields tighten their retracement.

Gold News
Can Maker break $1,450 hurdle as whales launch buying spree?

Can Maker break $1,450 hurdle as whales launch buying spree?

Maker holds steadily above $1,250 support as a whale scoops $1.21 million worth of MKR. Addresses with a 100k to 1 million MKR balance now account for 24.27% of Maker’s total supply. Maker battles a bear flag pattern as bulls gather for an epic weekend move.

Read more
Strategic implications of “Liberation Day”

Strategic implications of “Liberation Day”

Liberation Day in the United States came with extremely protectionist and inward-looking tariff policy aimed at just about all U.S. trading partners. In this report, we outline some of the more strategic implications of Liberation Day and developments we will be paying close attention to going forward.

Read more

RECOMMENDED LESSONS

7 Ways to Avoid Forex Scams

The forex industry is recently seeing more and more scams. Here are 7 ways to avoid losing your money in such scams: Forex scams are becoming frequent. Michael Greenberg reports on luxurious expenses, including a submarine bought from the money taken from forex traders. Here’s another report of a forex fraud. So, how can we avoid falling in such forex scams?

What Are the 10 Fatal Mistakes Traders Make

Trading is exciting. Trading is hard. Trading is extremely hard. Some say that it takes more than 10,000 hours to master. Others believe that trading is the way to quick riches. They might be both wrong. What is important to know that no matter how experienced you are, mistakes will be part of the trading process.

The Best brokers to trade EUR/USD

The Best brokers to trade EUR/USD

SPONSORED Discover the top brokers for trading EUR/USD in 2025. Our list features brokers with competitive spreads, fast execution, and powerful platforms. Whether you're a beginner or an expert, find the right partner to navigate the dynamic Forex market.

Read More

Strategy

Money Management

Psychology

Best Brokers of 2025