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, meaning the time value declines more quickly, as the expiration date gets closer because investors have less time to profit from the contract.
For options traders, understanding the power of time decay is important whether you’re buying calls or puts. Here are the basics you need to know.
How Time Decay Works
For traders who buy call options or put options with the intention of holding them until expiration, theta usually isn’t of great concern. 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 in the hope of making a quick profit must 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.
In other words, investors have a lower chance of making money with options that are unlikely to be in the money before expiration, so those contracts are not as valuable as others with longer time horizons.
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 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 & strike price
2. Time left until expiration
3. Implied volatility
4. Time decay (also known by the Greek letter theta)
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 decay are the factors that determine its extrinsic value.
• Intrinsic value. An option’s intrinsic value refers to the option’s value at the time of expiration, 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 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
How to Calculate Time Decay
The rate of an option’s time decay is measured by theta. The theta value of an option is often given in its options chain, but this shouldn’t be relied upon too heavily. It is only meant to be an estimate at any given time.
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 would likely increase 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.
Recommended: Understanding The Greeks in Options Trading
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 have to gain almost 15% in value in one week to make the trade profitable, 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.
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 would have an intrinsic value, tied to the underlying asset, but you might also pay a premium when they’re at full value.
As time passes, though, consumers will pay less for 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.
SoFi offers options trading, along with a library of educational resources about options to help you get started. The options trading platform has an intuitive and approachable design. Plus, investors will have the option of trading either through the mobile app or web platform.
Photo credit: iStock/Tatyana Azarova
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