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Options trading - Confusion About Time Value

By  Jun 12, 2012

Topics: Finance & Investing

Are there two types of option premium? or three? Many define only intrinsic and time value, but the truly important portion of premium is neither of these.

In fact, option premium has three distinct parts, and two -- intrinsic and time value -- are absolutely predictable. Intrinsic value represents the portion of in-the-money premium, and it increases or decreases point for point with price movement in the underlying. When the stock is at or out of the money, there is no intrinsic value.

Time value is also very specific and predictable. It declines as expiration approaches, and the closer it gets, the more rapidly time value falls. It finally reaches zero at the point the option expires and becomes worthless.

The third type, often lumped in with time value, may be called an option's extrinsic value, more often known as implied volatility. This is the only part of option premium that will change based on proximity between price and strike, time remaining to expiration, and uncertainty about the underlying price volatility (a range of uncertainty called historical volatility).

This is where all of the focus should be in analyzing and trying to time options trades. If you master the implied volatility factors and use them for timing, you can vastly improve your timing and thus, profits. Many online calculators help calculate volatility as well as the "Greeks" that track changes in both options and stocks.

One of the best of these calculators is provided free by the Chicago Board Options Exchange (CBOE). Go to www.cboe.com and then link to 'tools' and then to 'options calculator' -- this calculator provides you with everything, including delta and gamma, and volatility percentage. It is worth checking out.

Michael C. Thomsett is author of many options books with FT Press and other publishers. These books include "Options Strategies for the Conservative Investor" and "The Options Trading Body of Knowledge." He also is an instructor at the New York Institute of Finance and is Chief Education Officer at www.conservativetrade.com -- his Twitter is @ThomsettPublish