What is Time Decay

Time decay is the rate of change in an option (or other security) as time to expiration nears. Because options are wasting assets, their value declines over time. If an option approaches its expiry date and is not in the money, then 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.

Key Takeaways

  • Time decay is the rate of change in value to an option's price as it nears expiration. It is measured using theta.
  • Depending on whether an option is in the money, the theta of an options contract accelerates in the last month before expiration.
  • Using time decay as an options trading strategy is most successful for at the money options or options that are near expiration date and in the money.

Basics of 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. The extrinsic value (or the difference between its strike call and its intrinsic value) changes during time decay.

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.

Traders often hedge risk by taking multiple positions that may be a combination of long options and short options. The former generally have negative theta and the latter have positive theta, In such cases, the time-decay is a sum of individual thetas for all positions.

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.

Example of Time Decay

Suppose a $10 call option has a theta value of $1. This means that its time value will decline by $1 daily as expiration approaches. Thus, the option's value the next day will be $9 ($10-$1). Conversely, a put option has positive theta. This means that its price increases by the theta amount as expiration approaches.