Use Time Value to Select the Best Option Trade
The Nations NDX PutWrite Index sells fully-collateralized put options in order to generate superior risk-adjusted returns. It has succeeded with risk-adjusted returns which are superior to the underlying index over every historical timeframe measured: 2018, 3-year, 5-year, and since inception in 1994.
The NDX PutWrite sells put options which are just out-of-the-money and collects the time value the buyer is willing to pay. But what do we mean by the time value of an NDX option?
The price of an option has two components. The first component is the inherent or intrinsic value. The second component is the value of being able to wait to make a decision and get more information as time passes. That second component is the time value. Every option has time value, even if it is miniscule. Only options which are in-the-money have intrinsic value. A call option is in-the-money if the strike price of the option is below the market price of the underlying and a put option is in-the-money if the strike price is above the market price of the underlying.
The inherent or intrinsic value of an option is how much you’d get immediately if you exercised your option and then immediately closed your position. For a call option the inherent value is the amount by which the strike price of the call option is below the market price of the underlying. The inherent value for a put option is the amount by which the strike price of the put option is above the market price of the underlying. For example, if the Nasdaq-100 index is at 8259.81 (which happens to be yesterday’s close) then the 8300 strike put option would have intrinsic value and would be in-the-money. We know this because by exercising the put option we would sell the index at 8300 (the put’s strike price) when the best we could hope to do in the open market would be to sell it at 8259.81. But that option would also have time value which would be the amount a trader or investor is willing to pay in order to wait and see if the index rallies in price before option expiration. Waiting might allow the trader to sell the index for more than the 8300 strike price of our put option.
This 8300 strike put option closed yesterday at 166.90 and it has both intrinsic and time value. The intrinsic value would be 40.19 (8300.00 minus 8259.81). The reminder of the price of the option would be time value and that would be 126.71 (166.90 minus 40.19).
What influences the amount of time value an option has? Certainly the amount of time remaining to expiration is a huge factor but it’s not the only factor. The value of being able to wait and make a better informed decision, even among options which share an expiration date but which have different strike prices, has a huge influence on the amount of time value an option has.
For example, in the NDX options expiring on December 20, at yesterday’s close the option with the most time value was the 8260 put with 149.50 of time value. It’s no accident that the at-the-money option had the most time value but what happens to time value as the options get further from at-the-money? The 8000 put had just 74.85 of time value and the 7500 put had just 21.60 of time value. The 2000 strike put had just 0.025 of time value. We see the same phenomenon in call options. The 8500 call option had 49.55 of time value and the 9000 call option had just 1.80 of time value while the 10000 strike call option had 0.02 of time value.
The amount of time value in an option decreases as the strike price gets further from at-the-money and that makes sense; there’s not much value in holding that 9000 strike call option and hoping that it is in-the-money at expiration which was just 36 days away.
This decrease in time value is also true for options which are in-the-money. While the price of options increase as they become more in-the-money that’s exclusively because of the increase in intrinsic value; the time value of the option decreases.
This decrease in time value as options move further from at-the-money (in either direction) should inform the strike price we select regardless of our market thesis. There’s not much to be gained in a PutWrite which sells that 2000 strike put option for less than three cents. Similarly, there is not much to be gained in buying that 2000 strike put option since the likelihood of the underlying index dropping from 8259 to 2000 in 36 day’s time is pretty remote. It could happen but that put option would not be a very effective portfolio hedge.
This is why the Nations NDX PutWrite sells put options which are just out-of-the-money; they’re the put options with the most time value and this relationship is robust. The at-the-money options, either put or call, will always have the most time value and the amount of time value will decrease as the strike price of the option moves further from at-the-money. All traders and investors can use this understanding of time value to select the trade structure which best matches their risk or their market thesis.
You can follow Scott on Twitter: @ScottNations
Performance of an index is not illustrative of any particular investment. Index returns quoted represent past performance which is no guarantee of future results.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.