Glossary

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Time Decay

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See Also:

Expiration Date: Expiration Date is the last date on which an option may be exercised. This is the date on which an option contract automatically expires; the last day an option may be exercised. It is not uncommon for an option to expire on a specified date during the month prior to the delivery month for the underlying futures contracts.

On an option exchange, every 3rd Friday of the month is expiration day for monthly options. A number of option series expire on this day.

At expiration all call options with a higher strike price than the expiration price of the underlying stock/currency or index will be worthless. All series with a lower strike price will have value and will be exercised. In the case of put options the opposite applies.

For all holders of call options it will be optimal when the value of the positions at expiration is as low as possible.

Options expiration date is the most important factor in calculating an options price:

• The Black Scholes formula is used to price a European style option by factoring in current stock price, strike price, time until expiration, level of interest rates, any dividends and the volatility of the underlying security. The binomial model is used to price American style options.
• The binomial model calculates a tree of stock prices for given time intervals within the expiration period of the option using the volatility of a stock and time to expiration to find out how much a stock will increase or decrease in value. This calculation gives all possible prices of a stock. Then, the option prices of the stock are calculated backwards, from expiration to present. These prices are obtained by using risk neutral valuation. Ultimately, we get one price for the option.

Instrument: Instrument is a tradable asset such as a commodity, security, or derivative, or an index or value that underlies a derivative or could underlie a derivative.

Low: Low is the lowest price of the day for a particular futures or options on futures contract.

Option: Option is a contract that gives the buyer the right, but not the obligation, to buy or sell a specified quantity of a commodity or other instrument at a specific price within a specified period of time, regardless of the market price of that instrument. There are two types of options: Put Options and Call Options.

Time Value: Time value (also called Extrinsic Value) is the portion of an option's premium that exceeds the intrinsic value. The amount of money options buyers are willing to pay for an option in anticipation that over time a change in the underlying futures price will cause the option to increase in value. The time value of an option reflects the probability that the option will move into-the-money. Therefore, the longer the time remaining until expiration of the option, the greater its time value. In general, an option premium is the sum of time value and intrinsic value. Any amount by which an option premium exceeds the option's intrinsic value can be considered time value.

Volatility: Volatility is a statistical measurement of the change in price of a futures contract, security, or other instrument underlying an option over a given time period.

Volatility is one of the most important factors in an option's price. It measures the amount by which an underlying asset is expected to fluctuate in a given period of time. It significantly impacts the price of an option's premium and heavily contributes to an option's time value. In basic terms, volatility can be viewed as the speed of change in the market, although you may prefer to think of it as market confusion. The more confused a market is, the better chance an option has of ending up in-the-money. A stable market moves slowly.

Volatility measures the speed of change in the price of the underlying instrument or the option. The higher the volatility, the more chance an option has of becoming profitable by expiration. That's why volatility is a primary determinant in the valuation of options' premiums. There are options strategies that can be used to take advantage of either scenario.

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