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Intrinsic Value and
Time Value are two of the most important and
basic methods of judging the value of an option, in my
opinion.
If you are just
starting in option trading, these are the first two
methods you should learn to give you a basic idea of how
much an option is worth.
"Intrinsic
Value" is fairly simple. It is the portion of an
options price that is "in the money". At
expiration, an option will be worth 1 for 1 at whatever
intrinsic value is in the option. Until then, you have
to look at the delta of the option to figure out the
intrinsic value.
"Time Value",
is also known as "Time Decay" because the time
value of an option decreases every day. Time Value is a
little harder to figure out accurately by the average
trader. Time value is the value added to the price of an
option, above the intrinsic value, that the option
seller collects as a premium. The more time until
expiration, the more premium you will pay because the
more time you have for the option to move "in the
money".
"At The
Money" and "Out Of The Money" options
consist entirely of time value and will expire worthless
if they haven't moved into the money by expiration. You
can sell an "at the money", or "out of
the money" option before expiration, and collect a
profit or loss depending on other factors, but the time
value of an option will decay on a daily basis.
There is a general rule
of time decay that you can use. I have learned that the
Time Value of an option decreases on a slow but steady
basis until around the last two months of an options
life. After that, it starts a rapid decrease, and drops
really fast during the last month before expiration.
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