Options are one of the most popular types of derivatives, giving options holders the right to buy or sell a stock at a specified price. Options typically come with an expiration date by which the option holder must exercise them (or they can let it expire if exercising the option would cause them to lose money).
Many factors play a role in how the value of an option, meaning the premium the option buyer has to pay to the option seller, is determined. Things like the current price of the underlying stock, the strike price, and the time until expiration all have an effect.
Time decay, also called theta, describes the decrease in an option’s value as the expiration date nears. Learn how time decay matters and why you may need to know about it.
Definition and Example of Time Decay in Options
Time decay describes how the value of an options contract decreases, or decays, as the expiration of the option draws nearer.
For example, let’s say XYZ is trading at $40 and you want to buy a call option with a strike price of $50, and the expiration date is 180 days away. You may have to pay $200 for that contract, in this hypothetical example. If XYZ moves above $50 at any time in the next 180 days, you can exercise the option to buy shares at a discount.
Options contracts specify something called an expiration date as part of the contract specifications. When it comes to options in the U.S., the expiration date is the last date that an in-the-money options contract can be exercised. In most cases, the expiration date for an option contract is the Saturday after the third Friday of each month.
If there are only 30 days until the option expires, the same option might cost just $50 because there is less time for XYZ’s price to change to the extent that it makes exercising the option profitable.
With each day that passes, time decay will cause the value of an option to decrease. The dropping of the option’s value will typically accelerate as the expiration date draws nearer. The daily decrease in the option’s price will be higher the week before expiration than the month before expiration.
One thing to note is that, in general, options that are in the money experience less time decay because they have intrinsic value. Options at the money or out of the money experience more significant time decay.
- Alternate name: Theta (in trading)
How Does Time Decay Work?
Time decay works because of how options prices are determined. In general, options that are more likely to be exercised demand higher premiums. That means that options that are in the money or close to being in the money are more expensive than ones that are far out of the money. Similarly, options with expiration dates far into the future demand higher premiums.
An option is in the money if it would be profitable to exercise it. For example, if you own a call with a strike price of $50 on a stock trading at $55, that option is in the money. You could exercise it to buy shares and immediately sell them for a $5 profit.
Let’s dive deeper into why this is. If an option on a stock trading at $25 is $10 out of the money and expires tomorrow, the odds are low that the share’s price will change by $10 in a single day. If the option is $10 out of the money, but the expiration date is a year in the future, there’s much more time for the stock’s price to experience a large shift.
Options that are in the money have intrinsic value because you can exercise them for an immediate profit. Out-of-the-money options have value because of the possibility that changing stock prices will give those options intrinsic value. As the odds of an option gaining intrinsic value decrease, so too will the amount that people are willing to pay for it.
What It Means for Individual Investors
Investors interested in trading options should keep in mind that the expiration date of a contract affects its value. If you’re buying options very close to their expiration date, you should be prepared for their values to drop quickly.
Some options traders choose to capitalize on this by selling options close to their expiration date, but you have to be willing to accept the risks—including the potentially unlimited losses—involved with selling certain options
- Time decay describes how the value of an options contract decreases, or decays, as the expiration of the option draws nearer.
- As an option’s expiration date draws nearer, the value of the option tends to decrease.
- Out-of-the-money options are more affected by time decay than in-the-money options.
- Time decay has a small impact on options’ prices when the expiration date is a long time from now, and it accelerates as the expiration date gets closer.