Speculators familiar with buying options know it too well: the option value erodes over time if the stock stays level. The option value is composed of two components:
· Intrinsic value (for a call option above strike or a put option below strike)
· Time value
While the intrinsic value only depends on the option strike and the share price, time value is a different animal. It is larger for a stock that is most likely to end up ‘in the money’. Hence the time premium is higher the more of the following clauses are fulfilled:
· the stock price is pretty close to the strike (the option is ‘near the money’),
· the option has some time left for the stock to pass the strike price,
· the underlying exhibits a high volatility, making it more likely for the stock to bridge the gap to the strike price.
