Time Value

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There are some fascinating mathematics behind options. One of those interesting properties of options is the way they relate stock prices, option time value formula and dividends. If we know the prices for options on a stock, we can estimate from those prices what the next dividend payment is likely to be.

This is not due to any mystical power of options prices; it is just because the option market builds an estimate of dividends into the price of options, and they are usually pretty close in that estimate. If we know how, we can tease it out. If the option is in the money, it has intrinsic value equal to the amount by which it is in the money. If out of the money, it has no intrinsic value.

Here are some examples: In addition to its intrinsic value if it has anyan option may also have time value. Here is that table again, with option prices and time value added:. Notice that in this example, the Time Value for the Call option at each strike is equal to the time value for the Put option at the same strike.

In a certain kind of world this relationship would always hold true. Where the stock is now is where it has the greatest probability of being at any date in the future.

The farther away from its current price the stock has to move to reach another strike, option time value formula less chance there is that it will happen and therefore the less time value. That is, as I said earlier, if we lived in a certain kind of world.

That would be a world where option time value formula rates were option time value formula zero and stocks never paid dividends. If either non-zero interest or dividends do exist, then they are accounted for in option time value formula option prices. Think of it this way: This is not the most elegant formal description of interest in options, but it gives you option time value formula idea: Knowing the T-bill rate, the strike price, and the time to go, we can calculate how much interest could have been earned in that time.

Finally, we come to dividends. When a stock price drops for any reasoncall prices go down and put prices go up. The total of the option time value formula in the call and the increase in the put at the same strike adds up to the drop in the stock. And, with this piece of information we have a way to determine how much a dividend is likely to be. If an option has T days to go:.

We can easily see what the time value is for both the put and call, and we can easily calculate the interest amount; so the expected dividends can be calculated. Here is a real-life example: SPY was scheduled to pay a dividend on December It had options in whose lifetime this would occur which were due to expire 30 days out, on December Now we have what we need option time value formula plug into our formula.

Check out our Professional Options Trader course and learn how to make options work for you! Disclaimer This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of option time value formula reader.

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For an option trader these calculations should be subconscious and automatic. Morgan Chase stock with the strike price of 43 dollars and expiration date of 19 December On the options exchange this option is trading at 3. Morgan stock the underlying is trading at If you exercise this J. Morgan call option, you will be buying J. Morgan stock for 43 dollars the strike price. On the other hand, if you buy J. Morgan stock in the stock market, you pay The option is in the money , as its strike price is below the current market price of the underlying stock and you would be buying the stock cheaper with the option compared to buying the stock in the stock market.

Therefore you always have:. It is easy to figure out the time value, which is 3. Now we have another call option on J. The market price of J. Morgan stock is What is the intrinsic value?

How much money would you save by exercising the option buying the stock for 48 compared to buying the stock in the stock market for This call option is out of the money and its intrinsic value is zero. Now what is the time value? The market price of the option 1. There is only a little difference in these calculations for put options. Continue to the second part, which also contains a final summary, a note concerning at the money options, and an important final note about contract sizes: If you don't agree with any part of this Agreement, please leave the website now.

All information is for educational purposes only and may be inaccurate, incomplete, outdated or plain wrong. Macroption is not liable for any damages resulting from using the content. No financial, investment or trading advice is given at any time. Home Calculators Tutorials About Contact. Tutorial 1 Tutorial 2 Tutorial 3 Tutorial 4.