Question

1. Explain the effect of time to expiration on call and put premiums. Explain 3 different ways the time value of an option can be zero.

Please clearly explain the answer and list 3 ways and support your answer.

Answer 1

Most investors and traders new to options markets prefer to buy calls and puts because of their limited risk and unlimited profit potential. Buying puts or calls is typically a way for investors and traders to speculate with only a fraction of their capital. But these straight option buyers miss many of the best features of stock and commodity options, such as the opportunity to turn time-value decay (the reduction in value of an options contract as it reaches its expiration date) into potential profits.

When establishing a position, option sellers collect time-value premiums paid by option buyers. Rather than losing out because of time decay, the option seller can benefit from the passage of time, and time-value decay becomes money in the bank even if the underlying asset is stationary.

Intrinsic Value vs. Time Value
	In-the-money	Out-of-the money	At-the-money
Put/Call	Time-value decreases as the option gets deeper in the money; intrinsic value increases.	Time-value decreases as option gets deeper out of the money; intrinsic value is zero.	Time-value is at a maximum when an option is at the money; intrinsic value is zero.

The table below illustrates this concept and indicates when time value would be higher or lower and whether there will be any intrinsic value (which arises when the option gets in the money) in the price of the option. As the table indicates, deep in-the-money options and deep out-of-the-money options have little time value. Intrinsic value increases the more in the money the option becomes. And at-the-money options have the maximum level of time value but no intrinsic value. Time value is at its highest level when an option is at the money because the potential for intrinsic value to begin to rise is greatest at this point.