how time decay works
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 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 special considerationsto understand how time decay impacts an option we must first review what makes up the value of an option options contracts give investors the right to buy or sell 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 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 vs moneynessmoneyness 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 are 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 advantages and disadvantages of time decaytime decay is slow early in an option s life adding to its value or premium 