Time Value
Time value is the value that is attributed to the possibility that the option will increase in value during the time before expiry.
Time to Expiry
All else being equal an option with more time to expiry will have more time value than an option that has less time to expiry. The more time there is the more opportunity the underlying asset has to move.
Volatility of Underlying Security
The greater the volatility of the underlying the more people are willing to pay for an option's time value. Time value is higher on volatile securities because there is a possibility of larger profits.
Opportunity Cost
If you have a sum of money that you could earn interest on and you decided to spend that money on buying a stock, the interest that you could have earned is an opportunity cost. There are two factors that affect the opportunity cost: the risk-free rate of interest and the yield on the underlying (i.e. the underlying stock's dividend yield). Higher interest rates will mean higher call premiums and lower put premiums. Higher dividend yields will mean lower call premiums and higher put premiums. These two factors affecting opportunity cost have a minimal effect on the options price in comparison to other factors.
Time Decay
As illustrated in figure 1 the closer you get to the expiry date the faster an option's time value will deteriorate; this concept is called time decay. You will pay more money per day of time value for an option that is nearing expiry in comparison to an option that has a long time until expiry. All other factors being equal a nine month option would lose about 10% of its time value in the first 3 months, in the next 3 months it would lose about 30% of the original time value, and in the last 3 months the option would lose about 60% of its original time value.
Figure 1.
Time Value & Risk
In-the-Money options are options that have intrinsic value. A call option with a strike price that is below the stock price is in-the-money, and a put option with a strike price that is above the stock price is in-the-money.
The call option in figure 2 gives the holder the right to buy the stock for $10. The stock is currently trading at $15, this means that the call option has $5.00 of intrinsic value or the call option is $5.00 in-the-money.
The put option in figure 2 gives the holder the right to sell the stock for $20. The stock is currently trading at $15, this means that the put option also has $5.00 of intrinsic value or the put option is $5.00 in-the-money.
Figure 2.
The further in-the-money an option is in the less time value it will command. Deep in-the-money options are more expensive due to the large amount of intrinsic value. When an option is more expensive the buyer is risking more money, therefore the buyer won't be willing to spend as much money on time value.
Time Value & Probability of Profitability
Out-of-the-Money is the opposite to in-the-money options. A call option with a strike price that is above the stock price is out-of-the-money, and a put option with a strike price that is below the stock price is out-of-the-money.
The call option in figure 3 gives the holder the right to buy the stock for $20 while the stock is currently trading at $15. Exercising the call option would mean buying the stock for $5.00 more than the current price, this is another way of saying the call option is $5.00 out-of-the-money.
The put option in figure 3 gives the holder the right to sell the stock for $10 while the stock is currently trading at $15. Exercising the put option would be selling the stock for $5.00 less than the current price, this means the put option is $5.00 out-of-the-money.
Figure 3.
The further out-of-the-money an option is in the less time value it will have. When you buy a deep out-of-the-money options the stock has to move a lot in order for it to have any value on expiry. The probability of the option transaction being profitable is lower on deep out-of-the-money options anything on expiry, therefore the buyer won't be willing to spend as much money on time value.