What is a Time Premium?

Time premium, or time value, is the term given to the contribution that the time remaining before the expiration of an stock option makes to the total value of the option. An option is a financial instrument that gives the purchaser the choice to buy or sell 100 shares of a stock at a particular price, called a strike price. Every option has an expiration date, usually at the end of the third week of a stated month, at which time the option-holder relinquishes his or her right to trade the stock. The time premium applied to an option's value decays as the expiration date approaches, and it does so the fastest in the final month.

There is interdependence among the factors that contribute to the total value of an option. Besides time premium, some other factors that contribute are the price of the underlying asset in relation to the strike price, the volatility or anticipated volatility in the underlying asset's price, and any dividend that is paid out by the underlying asset. The factor that has the largest effect on the time premium is the price of the underlying asset in relation to the strike price.

When the price of the underlying asset is equal to the strike price of the option, the option is said to be at-the-money. At-the-money options have the greatest time value because the price of the underlying asset makes no contribution to the option's value. The only two contributors to the value of an at-the-money option at any snapshot in time are time and implied volatility. As the price of the underlying asset strays from the strike price of the option, the time premium shrinks, eventually becoming negligible at extremes in the difference between the two prices.

Options traders try to take advantage of different rates of time premium decay between options that expire in different months. Since the time premium of an option expiring during the current month will decay much more quickly than the time premium of an option expiring in a distant month, a trade called a calendar spread can be attempted. In a calendar spread, a trader buys a distance month's option and sells the current month's option – same underlying asset and strike price – at a loss equal to the difference in the prices of the two options. As the time value on the current month's option decays faster, the difference between the two prices will increase. The trader closes the trade by buying back the current month's option and selling the distant month's option at a gain equal to the now greater difference between the two prices, resulting in a net profit.