Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
Table of Contents
Time decay, as it relates to options trading, has to do with an option contract’s loss of value as it nears its expiration date. There are numerous variables in the mix when it comes to time decay, but knowing the basics of what the terms means, and how it can affect an investment strategy, can be important for investors.
Key Points
• Time decay refers to the reduction in an option’s value as its expiration date approaches.
• The rate of time decay is represented by theta, which accelerates as expiration nears.
• Options lose more value in the final month before expiration due to increased time decay.
• Intrinsic and extrinsic values are key components in options pricing, with extrinsic value subject to erosion from time decay.
• Understanding time decay may help options traders manage their options strategies and risk more effectively.
What Is Time Decay?
Time decay is the loss of an option’s value as it gets closer to expiration. An option’s time value refers to the extent to which time factors into the value — or the premium — of the option. Time decay accelerates, or declines more quickly, as the expiration date gets closer because investors have less time to exercise the contract.
For options traders, understanding time decay can be important whether you’re buying call options or put options. Here are the basics you need to know.
Recommended: Options Trading: A Beginner’s Guide
How Time Decay Works
The rate of change in the time value of an option is known as theta. For traders who buy options with the intention of holding them until expiration, theta usually isn’t of great concern. That’s because traders who hold contracts until the expiry date are hoping that the underlying security moves so far in their favor that the reward in terms of intrinsic value will outweigh any loss in extrinsic value.
But traders who want to close their options position prior to expiration may be more concerned about time decay. Because the security will have less time to move in their favor, the potential profit from intrinsic value is reduced, and the potential loss of extrinsic value becomes greater.
While both intrinsic and extrinsic value are important for options traders of all kinds, the type of options trading strategy a trader is using can influence which factors they put more emphasis on.
Understanding Options Pricing
Time decay isn’t a difficult options trading concept, but it does require a quick refresher about how options are traded and priced.
Four of the main variables that impact the price of an option are:
1. The underlying price and strike price
2. Time left until expiration
3. Implied volatility
4. Interest rates
The underlying price, strike price, and expiration date of the options contract are the main factors that determine its intrinsic value, while implied volatility and time to expiration are the factors that determine its extrinsic value.
• Intrinsic value. An option’s intrinsic value refers to the option’s value if exercised immediately, which depends on the price of its underlying security relative to the strike price of the contract. In other words, whether the option is in the money, out of the money, or at the money.
• Extrinsic value. Extrinsic value refers to how time and implied volatility can impact the option’s value, i.e., its premium. As the expiration date of the options contract approaches, there’s less time for an investor to profit from the option, so time decay or theta, accelerates and the option loses value.
Interest rates can also affect options prices, but this is more of a macro factor that doesn’t have to do with the specific contract itself.
Thus, time value represents the added value an investor has to pay for an option above the intrinsic value. Options are sometimes referred to as depreciating or wasting assets because they tend to lose value over time, since the closer the option is to expiration, the faster its time value erodes.
Recommended: Popular Options Trading Terminology to Know
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How to Calculate Time Decay
The rate of an option’s time decay is measured by theta. An option with a theta of -0.05 (theta is expressed as a negative value) would be expected to fall about $0.05 each day until expiration, but this may accelerate during the days and weeks leading up to the expiry date.
Greek values like theta are constantly changing, and can therefore be one of the most difficult factors to take into account when trading options.
Example of Time Decay of Options
Imagine an investor is thinking about buying a call option with a strike price of $40. The current stock price is $35, so the stock has to rise by at least $5 per share for the option to be in the money. The expiration date is two months in the future, and the contract comes with a $5 premium.
Now imagine a similar contract that also has a strike price of $40 but an expiration date that is only one week away and comes with a premium of just $0.50. This contract costs much less than the $5 contract because the stock would need to gain almost 15% in value in one week to reach profitability, which is unlikely.
Thus, the extrinsic value of the second option contract is lower than the first, because of time decay.
How Does Time Decay Impact Options?
Option time decay is pretty straightforward in principle. Things can be more complicated in practice, but in general, options lose value over time. The more time there is between now and the expiry date of the option, the more extrinsic value the option will have. The closer the expiry date is to the current date, the more time decay will have taken effect, reducing the option’s value.
The basic idea is that because there’s less time for a security to move one way or the other, options become less valuable the closer they get to their expiration dates. This isn’t a linear process though. The rate of time decay accelerates over time, with the majority of decay occurring in the final month before expiration.
The Takeaway
If you think about it, the time value of an option is similar to other things that have a value which is time dependent. A fresh loaf of bread, a new car, a newly built home — these items carry inherent value, but you might also pay a premium when they’re at full value.
As time passes, though, consumers may pay less for a loaf of bread that isn’t fresh — or a car or home that’s older — because time has eroded some of the value. Similarly, as an option gets closer to its expiration date, it too loses value owing to the effects of time decay or theta.
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FAQ
How does time decay work on options?
Time decay, also called theta, is the gradual erosion of an option’s extrinsic value as its expiration date approaches. Decay typically accelerates in the final weeks before expiration.
What happens to an option’s value as it approaches expiration?
As expiration approaches, an option’s extrinsic value declines while its intrinsic value — if any — remains tied to the underlying asset’s price. Options that are out of the money will lose value rapidly in the final days before expiration and may expire worthless.
How does moneyness affect time decay?
At-the-money options tend to experience the most significant time decay, as they carry the highest amount of extrinsic value relative to their price. In- and out-of-the-money options decay differently, with deep out-of-the-money options often losing value quickly as expiration nears.
What time of day do options decay?
Theta decay is generally calculated and applied at the close of each trading session rather than continuously throughout the day. That said, options positions can be more vulnerable to price swings during the open and close, when volatility tends to spike.
Photo credit: iStock/Tatyana Azarova
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
Options involve substantial risk of loss and the possibility an investor may lose the entire amount invested. Before starting options trading, investors should be familiar with the Characteristics and Risks of Standardized Options . TTax implications with options should be considered. Consult your tax advisor to understand any impacts to your taxes.
Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
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