What Is Time Decay?

Time decay, often referred to as theta, is a crucial factor in options trading. It describes the decline in an option's value as itsexpiration date approaches. As the expiration date nears, the time available to profit from the trade decreases, accelerating time decay. This concept is essential for investors to grasp, as it affects the option's premium and ultimately impacts profitability.

Understanding the Mechanics of Time Decay in Options

Time decay is the reduction in the value of an option as the time to theexpiration date approaches. The option'stime value indicates how much time influences its premium. The time value declines or time decay accelerates as the expiration date gets closer because there's less time for an investor to earn a profit from the option.

This figure, when calculated, will always be negative, as time only moves in one direction. The countdown for time decay begins as soon as the option is initially bought and continues until expiration.

Key Factors Influencing Time Decay

To understand howtime decay impacts an option, we must first review what makes up the value of an option. Options contracts let investors buy or sell securities, like stocks, at a set price and time. Thestrike price is the price at which the options contract changes to shares of the underlying security if the option is exercised.

Each option has apremium, which is its value and often the cost to buy the option.

However, there are a few other components that also drive the value of the premium. These factors include intrinsic value, extrinsic value, interest rate changes, and the volatility the underlying asset may exhibit.

Intrinsic Value

Intrinsic value is the difference between the market price of the underlying security—such as a stock—and the strike price of the option. A call option with a strike price of $20, while the underlying stock is trading at $20, would have no intrinsic value since there's no profit. 

However, a call option with a strike price of $20, while the underlying stock is trading at $30, would have a $10 intrinsic value. In other words, the intrinsic value is the minimum profit that's built into the option given the prevailing market price and the strike. Of course, the intrinsic value can change as the stock's price fluctuates, but the strike price remains fixed throughout the contract. 

Extrinsic Value

Theextrinsic value is more abstract than the intrinsic value, and it's more difficult to measure. The extrinsic value of options factors in the amount of time left before expiration and the rate of time decay leading up to the expiry. If an investor buys a call option with a few months until expiry, the option will have a greater value than an option that expires in a few days. 

The time value of an option with little time left until expiry is less since there's a lower probability of an investor making money by buying the option. As a result, the option's price or premium declines. 

The option with a few months until expiry will have an increased amount of time value and slow time decay since there's a reasonable probability that an option buyer could earn a profit. However, as time passes and the option isn't yet profitable, time decay accelerates, particularly in the last 30 days before expiration. As a result, the option's value declines as the expiry approaches, and more so if it's not yet profitable.

Comparing Time Decay and Moneyness in Options

Moneyness is the level of profitability of an option as measured by its intrinsic value. If the option isin-the-money (ITM) or profitable, it will retain some of its value as the expiration approaches since the profit is already built-in and time is less of a factor.

The option would have intrinsic value, while time decay would increase at a slower rate. However, time decay and the time value of an option are extremely important for investors to consider because they are key factors in determining the likelihood that the option will be profitable. 

Time decay is prevalent withat-the-money (ATM) options since there's no intrinsic value. In other words, the premium for an ATM option mostly consists of time value. If the option is out-of-the-money (OTM)—or not profitable—time decay increases at a faster rate. This acceleration is because as more time passes, the option becomes less and less likely to become in the money.

The loss of time value happens even if the value of the underlying asset has not changed during the same period. Another way to look at options contracts is that they arewasting assets meaning their value declines or depreciates over time.

Essentially, investors buy options with the best profit potential by expiry, and the remaining time influences the option's price. More time until expiry slows time decay, while less time speeds it up.

Pros and Cons of Time Decay in Options Trading

Example of Time Decay Impact on Options

An investor is looking to buy a call option with a strike price of $20 and a premium of $2 per contract. The investor expects the stock to be at $22 or higher at expiration in two months.

However, a contract with the same strike of $20 that's has only a week left until expiration has a premium of 50 cents per contract. The contract costs far less than the $2 contract since it's unlikely the stock will move higher by 10% or more in a few days.

In other words, the extrinsic value of the second option is lower than the first option with two months left until expiration.

The Bottom Line

Time decay, a critical concept in options trading, refers to the reduction in an option's value as expiration nears. This decay accelerates as the option approaches its expiration date, impacting its premium and making it vital for investors to consider when trading options.

Understanding the components of an option's value, such as intrinsic and extrinsic value, and monitoring how they change with time can guide traders in making more informed decisions. By acknowledging time decay's influence, investors can enhance their strategies to maximize potential profits and minimize unnecessary risks.