Calculate accurate option fair value using time value of option formula with the Black-Scholes model and comprehensive Greeks analysis
Fair value represents the theoretical price of an option based on the Black-Scholes pricing model. It's the price at which the option should trade in an efficient market, considering all relevant factors like underlying price, strike price, time to expiry, volatility, and interest rates.
The time value of an option is calculated as: Time Value = Option Price - Intrinsic Value. This represents the premium paid for the potential future profit opportunity. Time value decreases as expiration approaches, following the time decay principle captured by the Theta Greek.
While fair value is the theoretical price, market price is what traders actually pay. The difference between them can indicate market sentiment, implied volatility expectations, and potential trading opportunities. When market price exceeds fair value, the option may be overpriced.
Option value consists of intrinsic value (immediate profit if exercised) and time value (potential for future profit). Time value decreases as expiration approaches, while intrinsic value depends on the relationship between current price and strike price.
Theta measures the rate of time value decay. As expiration approaches, time value decreases exponentially. This is why options lose value over time even if the underlying asset price remains unchanged. Understanding time decay is crucial for option trading strategies.
Greeks measure how option value changes with various factors: Delta (price sensitivity), Gamma (delta sensitivity), Theta (time decay), Vega (volatility sensitivity), and Rho (interest rate sensitivity). Understanding Greeks helps manage risk and optimize strategies.