What is time decay in options?

Definition and Example of Time Decay in Options

Time decay, also known as theta, refers to the decrease in the value of an option as the expiration date approaches. It describes how the value of an options contract diminishes, or decays, as the expiration of the option draws nearer.

For example, let’s assume that XYZ is trading at $40 and you want to buy a call option with a strike price of $50, and the expiration date is 180 days away. You might have to pay $200 for this contract in this hypothetical example. If XYZ rises above $50 at any time during the next 180 days, you could exercise the option to buy the shares at a discount.

Note: Options contracts specify something called an expiration date as part of the contract’s specifications. With regard to options in the United States, the expiration date is the last date on which the option contract can be exercised in the money. In most cases, the expiration date of an options contract is the Saturday after the third Friday of each month.

If there are only 30 days left until the option expires, that same option might only cost $50 because there is less time for XYZ’s price to change enough to make exercising the option profitable.

With each passing day, time decay will cause the value of the option to decrease. The drop in the value of the option typically accelerates as the expiration date nears. The daily drop in the option price will be higher in the week before expiration than in the month before expiration.

One thing to note is that options that are in the money generally experience less time decay because they have intrinsic value. Options in the money or out of the money are subjected to more time decay.

How Does Time Decay Work?

Time decay works because of how option prices are determined. Generally, options that are more likely to be exercised require higher premiums. This means that options that are in the money or close to being in the money are more expensive than those that are out of the money. Similarly, options with expiration dates far in the future require higher premiums.

Note: An option is in the money if it is profitable to exercise it. For example, if you have a call option with a strike price of $50 on a stock that is trading at $55, then the option is in the money. You can exercise it to buy the stock and sell it immediately for a profit of $5.

Let’s delve deeper into why that is. If you have an option on a stock that is trading at $25 and that is out of the money by $10 and expires tomorrow, there is likely to be little chance that the stock price will change by $10 in a single day. If the option is out of the money by $10, but the expiration date is a year away in the future, there is more time for the stock price to change significantly.

In-the-money options have intrinsic value because you can exercise them for an immediate profit. Out-of-the-money options have value due to the possibility that those options may gain intrinsic value. As the chance of the option gaining intrinsic value diminishes, so does the value that people are willing to pay for the option.

What Does This Mean for Individual Investors?

Investors who are interested in trading options should keep in mind that the expiration date of the contract affects its value. If you are buying options that are very close to their expiration date, be prepared for their value to decrease rapidly.

Some options traders choose to take advantage of this by selling options close to expiration, but you should be ready to accept the risks – including unlimited loss risks – associated with selling options.

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Sources:

The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we verify facts and maintain the accuracy, reliability, and quality of our content.

U.S. Securities and Exchange Commission. “Investor Bulletin: Introduction to Options.” Accessed November 8, 2021.

Source: https://www.thebalancemoney.com/what-is-time-decay-in-options-5208791

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