What is Time Decay
Time decay is the rate of the change in an option (or other security) as time to expiration nears. Because 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. For options traders, the risk factor (known as the "Greeks") that measures the change in an options price - or a book of options value - over time is called the theta.
Time decay in options is most influential on at-the-money options and those closest to expiration. Longer-term options, such as LEAPS, do not lose much value on a daily basis. On the other hand, an option expiring in a day will soon lose all its intrinsic value.
Other assets that experience time decay are warrants, and instruments such as season tickets to sporting events that can be sold on secondary markets.
BREAKING DOWN Time Decay
Time decay is a factor that affects the value of a particular options contract. 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.
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.
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.
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.