Time Decay in Options Trading: Meaning, Examples & Formula

Time decay in options trading is like the clock ticking in chess: each passing moment reduces your time to make a strategic move, impacting your overall game plan. In options trading, understanding time decay is crucial, as it significantly influences the value of an option as it approaches its expiry date.

What is Time Decay in Options Trading?

Time decay, or theta, in options trading refers to the rate at which the value of an option diminishes over time as it nears its expiration.

• Significance: This phenomenon is crucial for both novice and experienced traders, as it affects the premium of options, especially in the final weeks leading to expiration.

Time Premium Erosion

The time premium is the part of an option’s price that exceeds its intrinsic value. As the option nears expiration, the time premium erodes, diminishing the overall value of the option. This erosion is beneficial for option sellers, as the decreasing time premium works in their favor, making it cheaper to buy back the options to close out a short position.

• Example: Consider an investor who buys a call option on “XYZ” with a strike price of $52, costing $2 per share. If the option has a theta of -0.05, its value will drop by five cents per day. After 10 days, it would decrease to $1.50 due to time decay.

Key concepts of Time Decay in Options

Time decay, often referred to as theta, is a crucial concept in options trading. Here’s how it works:

• An option’s premium is comprised of intrinsic value and extrinsic value. Intrinsic value is reflective of the actual value of the strike price versus the current market price. Extrinsic value is made up of time until expiration, implied volatility, dividends, and interest rate risks.
• Intrinsic Value: This is the true value if the option were exercised immediately. A call option would be, therefore, the difference between the price of the underlying and the strike price if the option is in-the-money.
• Extrinsic Value: Commonly referred to as time value, it is what an option is worth more than its intrinsic value. It reflects the probability that the option may go in-the-money before the expiration date.
• Erosion over time: The extrinsic value decreases with time to expiration because there is less time for the underlying price to move favorably. The rate of this erosion accelerates during the last few weeks prior to expiration.
• Non-linear decay: Time decay, however, does not decay uniformly. The rate accelerates as it nears expiry. Options that have more than 30 days to expire, for instance, will see their decay slow. Now, it is only when they reach the expiration path, more so in their last 30 days, that the rate of decay surges to its highest levels.
• Theta value: Theta is sometimes even referred to as the Greek letter that signifies time decay. Theta is a measurement of the change in the price of an option for each passing day. For example, if a call option has a theta of -.05, that means the option’s price will decrease by $0.05 every day, everything else being constant.

Impact of Time Decay in Options Trading

Time decay is especially noticeable for at-the-money (ATM) options, where the strike price is near the current price of the underlying asset. Since these options lack intrinsic value, their premium is mainly composed of time value, which declines quickly as expiration approaches.

Out-of-the-money (OTM) options, where the strike price is unfavorable compared to the current price of the underlying asset, are also significantly affected by time decay. As the expiration date draws nearer, the chances of these options becoming profitable decrease, resulting in an accelerated rate of time decay.

Factors influencing Time Decay in Options Trading

1. Time to Expiry: The time left until the expiration of an option forms a very important component of time decay. Normally, more time to expiration translates to a higher time value, and time decay accelerates as expiration draws closer; at times, it may be within the last 30 to 90 days.
2. Volatility: Market volatility does have an impact on the rate of time decay. While increasing volatility can push up an option’s premium, it may also accelerate its rate of decay as expiration draws closer.
3. Interest rates: Changes in interest rates have an effect on the time value of options. In general, an increase in interest rates benefits call options by lowering carrying costs, although it may be against the best interest of put options.

Practical example of Time Decay in Options Trading

Consider a hypothetical scenario where an investor purchases a call option on a stock called “A ltd” at a strike price of $52, with the option expiring in 30 days and costing $2 per share.

If the option’s theta is -0.05, it indicates that the option’s price will decrease by five cents per day, assuming all other factors like stock price and volatility remain constant. After 10 days, without any change in the stock price or other influencing factors, the value of the option would decrease to $1.50, purely due to time decay.

Strategies to mitigate Time Decay in Options

1. Trade options with a longer expiry: Instead of purchasing the one-month option, buy the six-month option. The more extended period takes time to decay slowly, thus offering the required time or allowing the underlying security some time to move favorably.
2. Sell options to gain from time decay: Sell at-the-money call options that have a few weeks until expiration. Since only a little time remains in these options, the value will drop quickly because of accelerating time decay, allowing the option to be bought back cheaper, or it can expire worthless with the premium captured as profit.
3. Options spreads: Sell a calendar spread by buying a longer-term call option and selling another call option that has the same strike price but is shorter in term. The time decay of the sold option compensates for the lower time decay of the purchased option, thereby reducing the net theta exposure.
4. Covered Call Writing: Be long shares of a stock and short call options on that stock. The premium collected for selling the calls operates to help offset time decay on the position, and if the stock stays flat or rises modestly, you get to keep the premium as profit.
5. Focus on high volatility strategies: Utilize straddles or strangles when the underlying instrument is very volatile. Although time decay will occur in these positions as well, the large moves which the underlying asset may experience can offset time decay losses to a great degree.

FAQs on Time Decay in options trading

1. What is the mechanism of time decay in options trading? Time decay reduces the option’s value as expiration nears, benefiting option writers by making it cheaper to close positions.
2. What factors influence the rate of time decay in options? Time to expiration, volatility, and interest rates are key factors influencing time decay.
3. How does time decay impact at-the-money (ATM) options? ATM options experience the highest rate of time decay due to their maximum time value.
4. Why do out-of-the-money (OTM) options experience faster time decay? OTM options have less intrinsic value, so their time value erodes more quickly as expiration approaches.
5. How does time decay affect in-the-money (ITM) options? ITM options have lower time decay as they possess more intrinsic value.
6. What is a practical example of time decay? An option with a Theta of -0.05 will decrease by $0.05 per day, assuming other factors remain constant.