Time value is the amount option buyers are willing to pay for the possibility that the option may become profitable prior to expiration due to favourable change in the price of the underlying. An option loses its time value as its expiration date nears. At expiration an option is worth only its intrinsic value. Time value cannot be negative. That is why option is called a wasting asset because on the expiry date the time value of the option becomes zero. When there is no time left there obviously cannot be time value. Time value works in favour of the seller of the option and against the buyer of the option. This applies to calls and puts. Time value is normally the residual left in the stock price after the intrinsic value is removed. Here is what you need to know about time value.

Intrinsic value of option + time value of the option is the option price. Since intrinsic value and option price are known, it is time value that is the residual element. Let us understand the concept of time value in 3 different ways.

Firstly, assume that the Tata Steel 550 call option in the December expiry is quoting in the market at Rs.33, when the stock price of Tata Steel is Rs.574. In this case, the intrinsic value of the option is the (Spot price – Strike Price), which is Rs.24 (574 – 550). However, the option is quoting at Rs.33. Therefore the residual value of Rs.9 (33 – 24) is the time value of the option. If the market price of Tata Steel remains stagnant at Rs.574, then the intrinsic value will remain at Rs.24, but the option price will keep falling because the time value of Rs.9 will gradually trend towards zero.

In the above case, what if the Tata Steel 550 call option has an option price of Rs.7 but the stock price is Rs.543. In this case, the intrinsic value of the option is zero since the market price is below the strike price. Hence, the Rs.7 market price is entirely consisting of time value only.