Time Decay

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Time Decay

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.

Key Takeaways

  • 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

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.

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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.

Time Decay in Options Trading

The basic definition of time decay in the context of options is relatively straightforward; it’s basically the reduction in value of an options contract as reaches its expiration date. Essentially, the value decays as time progresses, hence the term. It’s vital for any trader to know about time decay because it can play a very big part in whether trades are profitable or not.

At any given time, any contracts that you own or have written are being affected by time decay, so you really need to understand its role and the effect it can have on your positions. On this page, we provide an in depth explanation of exactly what it is and how it works.

  • Time Decay of Options Explained
  • Why Time Decay Happens
  • Rate of Time Decay
  • How Time Decay Effects Options Traders

Time Decay of Options Explained

As explained above, time decay is the erosion of the value of options as time progresses. To explain further, we must look at how the price of an option is effectively made up of two separate components: intrinsic value and extrinsic value.

Intrinsic value is relatively simple to calculate because it essentially represents the theoretical built in profit of an options contract at a specific point in time. For example, a call with a strike price of $20 on an underlying security that was trading at $25 would have an intrinsic value of $5. Technically it could be exercised to buy the underlying security at $20, which could then be sold at the market price of $25 for a $5 profit. This $5 profit represents the intrinsic value of the contract. If the underlying security was trading at $20 or below, then the call would have no built in profit and therefore no intrinsic value.

Extrinsic value is slightly more complex, because it’s less tangible than intrinsic value. In some ways, the extrinsic value is really the true cost of owning an options contract, because it’s effectively the money that you pay for the possibility of being able to benefit from price movements in the underlying security. For example, if you bought at the money calls with a strike price of $30 on an underlying security that was trading at $30 there would be no intrinsic value, only extrinsic value. If the cost of each contract was $2, then you would basically be paying $2 for the right to take advantage of any upward price movement of the underlying security.

There are a number of factors that affect extrinsic value, and time is one of those factors. In fact, extrinsic value is often referred to as time value because time is considered to be the most important factor. Because contracts have a fixed expiration date, there’ always a limited amount of time for the price of the underlying security to move favorably for the holder. The longer there is until expiration date, the more chance there is for the underlying security to move and therefore the more chance for the holder to make a profit.

As such, the amount of time remaining until expiration date usually has a significant impact on extrinsic value. The general rule is that the more time there is left, the higher the extrinsic value. As the expiration date draws closer, the extrinsic value gets lower and that’s basically time decay in action.

Why Time Decay Happens

We can see then that time decay is basically the process by which extrinsic value diminishes as the expiration date gets nearer. This is really quite logical, because it makes sense that an option would be less valuable if there is less time for the relevant underlying security to move in price. Consider the example above where we mentioned at the money calls with a strike price of $30 and a cost of $2. If you were buying those calls, then you would need the underlying security to move to $32 by expiration just to cover the cost of buying them. If they had a long time until expiration, then this might represent a sound investment.

However if there was only a few days until expiration and the security was still at $30, then the calls would be probably be trading at much lower than $2 as there would be much less chance of the security moving enough in just a few days. The extrinsic value of $2 would have reduced significantly and, with no intrinsic value involved, the price of the calls would also have decreased accordingly.

If you held on to those calls all the way until expiration and the underlying security still remained at $30, then they would expire worthless. This is essentially how and why time decay happens, and it’s also why options are considered to be depreciating assets.

Rate of Time Decay

It should be noted that time decay isn’t a linear function, meaning it doesn’t happen at a fixed rate. If an options contract has, say, 150 days until expiry, then the extrinsic value doesn’t diminish at the same rate for each of those 150 days. With 150 days to go until expiration, the rate will be quite slow, whereas with only 40 or 50 days to go the rate will be faster. Once there is less than one month to go, time decay will typically have much more impact on the extrinsic value. Basically, the closer the expiration date, the faster the rate of time decay.

The rate of time decay is measured by one of the options Greeks, Theta. The Theta value of an options contract theoretically defines the rate at which its price will decline on a daily basis. For example, the price of a contract with a Theta value of -0.03 would be expected to fall by approximately $0.03 each day.

You can find out the Theta value of most contracts by studying the appropriate options chain, but you should be aware that it’s only a theoretical value and not a guarantee of the rate of time decay. It can be useful to help with predicting the effect of time decay, but shouldn’t necessarily be relied upon. Because the rate accelerates as the expiration date gets closer to expiration, the Theta value will change accordingly.

How Time Decay Effects Options Traders

The main effect that time decay has on traders is that the extrinsic value of any contracts that they own is likely to be diminishing for every day they own them. For traders that simply buy calls and puts with a view to holding them until expiration, time decay isn’t really an issue: even though it will still of course be in effect.

The idea of holding options until expiry is that, although the extrinsic value will have completely eroded by that point, the underlying security will move favorably enough to make up for the loss of the extrinsic value and they still return a profit. As a simple example, if you bought at the money calls (with the strike price equal to the current trading price of the underlying security) for $1, then as long as the underlying security went up by more than $1 in price then you will make a profit.

However, for traders that are buying contracts and planning to close their position prior to expiration, time decay really does need to be taken into consideration for each and every trade. In order to close a position early and make a profit, the intrinsic value of any options bought must increase by an amount larger than the effect of time decay.

For example, if you bought contracts and the intrinsic value went up by $1 but the time decay effect reduced the extrinsic value by $1.20, then you would be in a losing position.

It’s obvious that to make money you need the price of the contracts you buy to go up in value before you sell them. However just because you own calls on an underlying security that’s going up in value, or own puts on an underlying security that is going down in value, it doesn’t necessarily mean that those contracts are actually going up in price because time decay could be effectively wipe out any gains from the increase in the intrinsic value.

Essentially, it’s absolutely vital that you take into account the effect of time decay on the price of options when you are planning your entry and exit points for all your trades.

It’s also possible to use time decay to your advantage, or at least neutralize its effect. Although it has a negative effect on the holders of options contracts, it has a positive effect on the writers of them. When you write options contracts, the extrinsic value of them at the time of writing them is basically your upfront profit. If their intrinsic value doesn’t increase between the point of writing them and the point of them expiring, then you will retain that profit.

All the extrinsic value will have eroded due to time decay, meaning you have actually benefited from the process. Even if the intrinsic value does increase, that will at least be offset in part by the reduction in extrinsic value. Although you may still make a loss, the effects of time decay will at least minimize that loss in some way.

You can neutralize the negative effect of time decay on buying options by also writing options at the same time. Many trades involve creating options spreads, where you buy specific contracts and then contracts options based on the same underlying security. For example, you could buy in the money calls (with some intrinsic value) on a particular stock and simultaneously write out of the money calls (with no intrinsic value) on the same stock.

The contracts that you have bought could return a profit if the stock moves favorably, but that profit might be reduced by the loss of extrinsic value due to time decay. However, you would also be benefitting from the eroding extrinsic value in the contacts that you have written.

All these examples simplify the effect of time decay, but they also show how the basic principle works. It’s clearly a very important aspect of trading that can both positively and negatively affect your trades. Understanding how it works and how it impacts your potential profits is the key to being successful.

Time Decay

Definition: Time Decay is the inclination for options to decrease in worth as the expiration date draws near. The extent of the time decay is inversely connected to the changeability of that option. Time Decay, also referenced to as theta, may be measured by watching the rate of decrease in the amount of an option over time.

Why does it happen?
Options have an intrinsic and an extrinsic worth. As time expires and the finish date of the option approaches, the value of the option loses its extrinsic value and gets near to its intrinsic value.

For instance, the worth associated with trading diminishes with time, meanwhile the value associated with the actual difference between the strike price and the underlying stock price becomes more noticeable.

The more often the option is traded, the less is the result of time decay as market forces maintain the extrinsic value. Also a thinly traded option is subject to considerable time decay as the extrinsic value rapidly dissipates due to a lack of demand.

Example:
Take for instance, AAPL stock price stays constant at $335 for 10 days before the options expiration date.

Price of $340 Call Option 10 days before expiration: $1.05
Price of $340 Call Option 5 days before expiration: $0.50
Price of $340 Call Option on day of expiration: $0.00

The intrinsic value of the call option was $0.00 as it was out of the money throughout the 10 days. Because of supply and demand of the option, the extrinsic value gave a price to the option. As the expiration got closer, the price of the option fell short of its extrinsic value and moved towards its intrinsic value.

Long and Short of Time Decay:

Time Decay can be a useful tool for Options Writers (shorts).

If you can estimate with the help of Theta what the rate of decay of an option is, it is possible to make good profits from the difference in the premium received and premium paid at or before expiration.

Generally, time decay begins gathering momentum around 30-60 days before the expiration date of an option.

Contrary to holding options for a long period of time, especially out of the money, one needs to be good at predicting where the price of the underlying stock will close at the date of expiration.

The investor must realize that because of time decay, the price of their option will not move as much as it does the prior day.

Options lose value every day the stock price does not go in the favor of their option.

Conclusion:
Time Decay increases the chance of a loss in option price daily for a long option holder, while decreasing the risk of a price increase for a writer of an option. Time decay is best measured via the Greek, Theta.

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