Lesson 3 of 6 · 11 min
Time value and time value decay
An option's price is its exercise value plus its time value, the extra a buyer pays for the chance that the underlying moves favourably before expiration.
In short
- Option price = exercise value + time value, so time value = price − exercise value.
- Time value reflects the chance that the underlying moves favourably before expiration. Losses are capped, so extra dispersion only helps the holder.
- Time value is always positive before expiration and shrinks to zero at expiration: time value decay.
- An out-of-the-money option has zero exercise value, so its whole price is time value.
- Decay is a cost to the option buyer and a benefit to the option seller, all else equal.
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