Option Pricing Part 3

Time Value

The time value mainly represent the effective period of an option. The longer the time to expiry the higher the time value. But it is also influence by the following factors:
-- Volatility of the underlying share
-- Interest rate
-- Dividend payment
-- Market expectation

Out of these factors, I will say from personal experience the most important one is volatility. There is two type of volatility: Historical Volatility (HV) and Implied Volatility (IV). HV is a measure of how volatile the stock has been in the past. IV is how the market expects the volatility of a certain stock to be in the future. Therefore IV is much more important than HV since it will influence the current price of the option. So an option with high IV will be more expensive than option with low IV assuming other factors are equal. Most option trader will try to sell the option with high IV (the more expensive one) and buy the option with low IV (the cheaper one).


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Trading Room
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