Option value (i.e.,. price) is estimated via a predictive formula such as Black-Scholes or using a numerical method such as the Binomial model. This price incorporates the expected probability of the option finishing "in-the-money". For an out-of-the-money option, the further in the future the expiration date - i.e. the longer the time to exercise - the higher the chance of this occurring, and thus the higher the option price; for an in-the-money option the chance of being in the money decreases; however the fact that the option cannot have negative value also works in the owner's favor. The sensitivity of the option value to the amount of time to expiry is known as the option's theta. The option value will never be lower than its IV.
As seen on the graph, the full call option value (IV + TV), at a given time t, is the red line.
Read more about this topic: Option Time Value
Famous quotes containing the word option:
“A self-respecting nation is ready for anything, including war, except for a renunciation of its option to make war.”
—Simone Weil (1909–1943)
“Our passional nature not only lawfully may, but must, decide an option between propositions, whenever it is a genuine option that cannot by its nature be decided on intellectual grounds; for to say, under such circumstances, “Do not decide, but leave the question open,” is itself a passional decision—just like deciding yes or no—and is attended with the same risk of losing the truth.”
—William James (1842–1910)