The definitions of intrinsic and time premium in options prices are important to grasp and understand, explains options expert Jay Soloff, editor of Options Floor Trading Pro — and a participant in The Interactive MoneyShow Virtual Expo on Sept. 15-16.
With our covered call strategies, the time premium portion of an option’s price becomes a large portion of our realized profits.
Intrinsic value is the portion of the price of an option equal to the amount the option is in-the-money (ITM). For example, stock XYZ currently trades for $31.00 per share. With a call option on XYZ with a $30.00 strike price, the option is $1.00 ITM, so $1.00 of the option’s current price is intrinsic value.
Time premium is the portion of an option’s current value that is not intrinsic value. Using the XYZ example, if the $30.00 strike price call currently lists for $1.50 (with the stock at $31), the time premium is $0.50. The math is the $1.50 option price minus the $1.00 of intrinsic value, leaving 50 cents of time premium. The value for options with strike prices out of the-money will be entirely time premium.
We are options sellers, so the goal is to generate attractive returns based on the amount of time premium in the options we sell and the time until the expiration dates. Here are some features to understand about time premium:
The amount of time premium in an option price depends on the time remaining until expiration and the volatility of the underlying share price. The more time and the higher the volatility, the higher the option price.
However, picking options to sell with a long time to expiration and higher volatility also increases the risks that the covered call trade will not work out as you want.
There are some characteristics of time premium that you should understand. Very important is that time premium erodes as the date gets closer to expiration.
This means if we sell a call option with 30 days until it expires, the value of the time premium on that option we sold (we are short the call) will decline over the thirty days and be down to zero time premium when the short call expires. If left until expiration, the time premium in sold options becomes income from our covered call trades.
The other characteristic covers the pricing of an option that has gone in the money (ITM), meaning the share price has moved above the option strike price.
However, while the option price will go up to match the amount the contract is ITM, those price increases will be intrinsic value, and the time premium will continue to erode as the expiration date approaches.
The time premium decay means that if you are short a call that has gone ITM and you don’t want the shares to be called away, you can buy back the short call, with very little change to your trade and account value. Let me illustrate:
Using the hypothetical XYZ stock, we sold the $30 strike calls when the stock price was at $29.00. If the option is exercised, we will receive $30 for the shares, making a $1.00 per share profit plus the amount received for selling the calls.
As we get close to expiration, XYZ has increased to $32 per share, putting the short calls $2.00 ITM. If you want to keep the shares, you need to buy back the short call. As expiration approaches, the time premium will mostly disappear, so in this case, you would likely pay $2.02 to $2.05 to buy back the option.
Paying the just over $2.00 to buy to close the calls lets you keep the shares worth $32.00 as opposed to having them called away for $30.00.
