Explanation
The time value of an option is defined as the difference between the option's market price (premium) and its intrinsic value.
Key concepts:
- Option price (premium) = Intrinsic value + Time value
- Intrinsic value = The amount by which an option is in-the-money
- For a call option: Max(0, Underlying price - Strike price)
- For a put option: Max(0, Strike price - Underlying price)
- Time value = Option price - Intrinsic value
Why option A is correct:
- Time value represents the additional premium that traders are willing to pay for the possibility that the option may become more valuable before expiration.
- It reflects factors like time to expiration, volatility, interest rates, and dividends.
Why other options are incorrect:
- Option B: "Strike price minus underlying price" is not a standard option valuation metric. For a put option, this could be negative if the underlying price is above the strike price.
- Option C: "Strike price minus intrinsic value" doesn't make sense mathematically or conceptually. The strike price is a fixed value, while intrinsic value depends on the underlying price.
Example:
If a call option with strike price $100 is trading at $8 when the underlying stock is at $105:
- Intrinsic value =
$105 - $100 = $5
- Time value =
$8 - $5 = $3
- The
$3 represents the time value component.
