What Is Time Decay?
Time decay is a measure of the rate of decline in the value of an options contract due to the passage of time. Time decay accelerates as an option's time to expiration draws closer since there's less time to realize a profit from the trade.
Time decay is also called theta and is known as one of the options Greeks. Other Greeks include delta, gamma, vega, and rho, and these formulas help you assess the risks inherent with an options trade.
Time Decay—The Silent Killer
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.
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.
- Time decay is the rate of change in value to an option's price as it nears expiration.
- Depending on whether an option is in-the-money (ITM), time decay accelerates in the last month before expiration.
- The more time left until expiry, the slower the time decay while the closer to expiry, the more time decay increases.
Pricing an Option
To understand how time decay impacts an option, we must first review what makes up the value of an option. An options contract provides an investor the right to buy (a call), or sell (a put), 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 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.
Extrinsic Value and Time Decay
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.
Time Decay and Moneyness
Moneyness is the level of profitability of an option as measured by its intrinsic value. If the option is in-the-money (ITM) or profitable, it will retain some of its value as the expiration approaches since the profit is already built in and time is less of a factor. The option would have intrinsic value, while time decay would increase at a slower rate. However, time decay and the time value of an option are extremely important for investors to consider because they are key factors in determining the likelihood that the option will be profitable.
Time decay is prevalent with at-the-money (ATM) options since there's no intrinsic value. In other words, the premium for an ATM option mostly consists of time value. If the option is out-of-the-money (OTM)—or not profitable—time decay increases at a faster rate. This acceleration is because as more time passes, the option becomes less and less likely to become in-the-money.
The loss of time value happens even if the value of the underlying asset has not changed during the same period. Another way to look at options contracts is that they're wasting assets meaning their value declines or depreciates over time.
Essentially, investors are buying options that have the greatest probability of making a profit by expiry and how much time is left determines the price investors are willing to pay for the option. In short, the more time left until expiry, the slower the time decay while the closer to expiry, the more time decay increases.
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
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
Real World 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.
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.