Time decay, also known as theta decay, is a concept in options trading that refers to the gradual reduction in the value of an option over time. It is a result of the diminishing time left until the option’s expiration date.
As an option approaches its expiration, the time value decreases, impacting the overall option premium. This decay occurs because the probability of the option finishing “in the money” diminishes as time passes. Time decay is more pronounced in options with shorter expiration periods.
The impact of time decay is significant for option buyers, as they face a constant erosion of the option’s value. On the other hand, option sellers can benefit from time decay since they collect premiums and profit as the option loses value.
How Time Decay Works
Time decay is the reduction in the value of an option as the time to the expiration date approaches. An option’s time value is how much time plays into the value—or the premium—for the option. 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.
Alt: Graph illustration of Time Decay
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.
To understand how time decay impacts an option, we must first review what makes up the value of an option. Options contracts give investors the right to buy or sell securities, such as stocks, at a specific price and time. The strike price is the price at which the options contract changes to shares of the underlying security if the option is exercised.
Each option has a premium attached to it, which is the value and often the cost of purchasing 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.
Alt: Illustration of Intrinsic Value
Extrinsic Value
The extrinsic 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.
Alt: Extrinsic Value calculation
Example of Time Decay
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.
Strategies to Navigate Time Decay
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.
Impact on Options Traders
For Option Buyers:
Time decay can be a significant challenge for option buyers. The value of the option diminishes over time, and if the underlying asset doesn’t move favorably, the option may expire worthless, leading to a loss.
For Option Sellers:
Conversely, option sellers can benefit from time decay. They receive premiums from buyers, and as time passes, the value of the option decreases. If the option expires worthless, the seller keeps the premium, resulting in a profit.
Strategies to Navigate Time Decay
Option Spreads: Utilise spreads to mitigate the impact of time decay by combining long and short option positions.
Calendar Spreads: This strategy involves buying and selling options with different expiration dates, aiming to benefit from the differing rates of time decay.
Regular Monitoring: Stay vigilant and regularly reassess your options positions, adjusting your strategy as the expiration date approaches.
Advantages and Disadvantages of Time Decay
Pros:
- Time decay is slow early in an option’s life, adding to its value or premium.
- When time decay is slow, investors can sell the option while it still has value.
- Time decay’s impact on an option’s premium helps investors determine whether it’s worth pursuing.
Cons:
- Time decay accelerates as an option’s time to expiration draws closer.
- Measuring the rate of change in time decay of an option can be difficult.
- Time decay occurs regardless of whether the underlying asset’s price has risen or fallen.
Closing Thoughts
understanding time decay is essential for making informed decisions. Whether you’re an option buyer hoping for a swift market movement or an option seller capitalizing on time erosion, recognizing the dynamics of time decay is key to navigating the complexities of the financial markets.
