What is 'Time Decay'
Time decay is the ratio of the change in an option's price to the decrease in time to expiration. Since options are wasting assets, their value declines over time. As an option approaches its expiry date without being in the money, its time value declines because the probability of that option being profitable, or in the money, is reduced.
BREAKING DOWN 'Time Decay'Time decay is a factor that affects the value of a particular options contract. As the expiration date of a particular options contract approaches, the result of the contract is easier to predict. In cases of in-the-money options, such as puts where the price of the underlying is listed as less than the strike price, these contracts are less likely to produce a profit for a new buyer based on what a seller would request.
In cases of out-of-the-money options, such as puts where the price of the underlying is listed as more than the strike price, these contracts are unlikely to shift to in-the-money options, lowering the value by the nature of the contracts probable outcome.
The market finds these options too expensive compared to other strike prices or futures. As such, the holders of deep-in-the-money options nearing expiry discount the time value to attract buyers and in turn realize the intrinsic value. The greater the certainty about an option's expiry value, the lower the time value. Conversely, the greater the uncertainty about an option's expiry value, the greater the time value.
Also known as theta and time-value decay, the time decay of an option contract begins to accelerate in the last 30 to 60 days before expiry, provided the option is not in the money. In the case of options that are deep in the money, time value decays more rapidly.
An options contract provides an investor the right to buy, known as a call, or sell, known as a put, specified stocks or commodities at a specific price at a specific time. The price specified in the contract is referred to as the strike price. The purpose of options is to attempt to predict the direction a stock will move, allowing a person the option to buy at a price lower than the stock’s value or sell at a price higher than a stock’s value, resulting in a profit.
Understanding Wasting Assets
A wasting asset is any asset that has a limited lifespan. This leads the value of the asset to decrease over time due to the fact the outcome is more likely to be known closer to the expiry date. This can be especially true of options that are out of the money since, as more time passes, the option becomes less and less likely to become in the money. These losses are experienced even if the value of the underlying asset has not changed during the same time period.