What is Time Value?
In the options trading world, there are two components that make up an option's price. The first is intrinsic value (which accounts for the underlying security's perceived value), and the second is time value.
Time value is basically the risk premium that the seller requires to provide the option buyer with the right to buy/sell the stock up to the expiration date. Think of this component as the 'insurance premium' of the option.
How Does Time Value Work?
Option Price - Intrinsic Value = Time Value
For example, if Company XYZ is trading for $25 and the XYZ 20 call option is trading at $7, then we would say that the option has an intrinsic value of $5 ($25 - $20 = $5), and a time value of $2 ($7 - $5 = $2).
Options that have zero intrinsic value are comprised entirely of time value.
Why Does Time Value Matter?
Buyers pay for time value because they expect the option premium to increase in the future, usually caused by an anticipated change in the price of the underlying futures contract. The longer an option has before it expires, the more time (and greater chance) it has to become in the money. As the expiration date approaches, time value decreases (because there is less chance that it will expire in the money).
Time value is easy to see when looking at the price of an option, but the actual derivation of time value is based on a fairly complex equation. Basically, an option's time value is largely determined by the amount of volatility that the market believes the stock will exhibit before expiration. If the market does not expect the stock to move much, then the option's time value will be relatively low. Meanwhile, the opposite is true for stocks that are expected to be very volatile. High-beta stocks, or those that tend to be more volatile than the general market, usually have very high time values because of the uncertainty of the stock price prior to an option's expiration.