Time Value

A call option whose strike price sits above the current market price of the underlying stock trades at a premium of 2. That premium consists of

1. A.intrinsic value of 2 and no time value at all.Wrong. Immediate exercise would cost more than buying the stock outright, so nothing is intrinsic here.
2. B.time value of 2 and no intrinsic value at all.Correct. With the strike above the market, everything the buyer is paying for lies in the future.
3. C.intrinsic value and time value in roughly equal proportions.Wrong. That split requires the option to be in the money, which a strike above the market is not.
4. D.neither, since an out-of-the-money option cannot command a premium.Wrong. The chance of a move before expiration is exactly what buyers are paying for.

Why: An option premium always divides into intrinsic value, which is what the holder would gain by exercising immediately, and time value, which is what the market charges for the possibility of a favourable move before expiration. A call whose strike lies above the market price would produce nothing on immediate exercise, so its intrinsic value is zero and the whole premium is time value. That is why an out-of-the-money option loses value steadily if the underlying does not move. Once the stock rose above the strike, intrinsic value would appear and the premium would split between the two components.

A client holds a long call option and the underlying stock trades at essentially the same price for several weeks. Over that period the premium on his option will generally

1. A.decline, because time value erodes as the expiration date draws nearer.Correct. Time is an input in its own right, and it is consumed whether or not the stock moves.
2. B.remain unchanged, since the price of the underlying stock has not moved.Wrong. The premium has two components, and the passage of time consumes one of them regardless.
3. C.rise, because a longer record of stability makes the option safer to hold.Wrong. Stability reduces the likelihood of the very move the option needs in order to pay.
4. D.decline, but only where the option is currently in the money.Wrong. An out-of-the-money option is nothing but time value, so it decays fastest of all.

Why: An option is a wasting asset because one of the two components of its price is the time remaining before expiration. Holding the underlying still, the passage of time removes optionality without replacing it with anything, so the premium erodes and the erosion accelerates as expiration approaches. This is why a long option position needs the underlying to move, and to move soon enough, before it can be profitable. A rise in implied volatility could offset the decay for a time, but nothing in a period of price stability supplies one.

As an option approaches expiration, its time value:

1. A.Increases steadilyTime value is payment for the chance of a favorable move, and each passing day leaves fewer days in which that move can happen. The thing being paid for shrinks, so its price cannot climb.
2. B.Decays toward zeroCorrect - time decay accelerates near expiry.
3. C.Becomes negativeNegative time value would put an option below its intrinsic value, letting a holder exercise immediately for more than the contract cost. That arbitrage is what holds the floor at zero, so decay stops there rather than passing through it.
4. D.Stays constantConstant time value would make a one-week option worth as much as a one-year option on the same stock. A longer window is plainly worth more, so the value has to fall as that window closes.

Why: Time value erodes (time decay/theta) as expiration nears, reaching zero at expiration.

In March, a customer buys a call on Trenholm Motors that expires in January of the second following year, and is surprised by the size of the premium. A LEAPS option is:

1. A.A long-term option expiring more than a year outCorrect - Long-term Equity AnticiPation Securities.
2. B.An option expiring the next dayThat is the shortest life a listed contract can have, the precise opposite of the LEAPS design. The words long-term in the name are what this answer turns on.
3. C.A mutual fundA mutual fund is a pooled investment company, not a contract conveying the right to buy or sell at a strike price. LEAPS remain options in every respect; only their time to expiration is unusual.
4. D.A type of bondA bond is a debt obligation that pays interest and returns principal. LEAPS confer no creditor claim and pay nothing along the way; they expire, which no bond does.

Why: LEAPS are long-term options, typically with expirations more than one year in the future.