Options Time Decay Explained
Time decay is the rate at which an option's value declines as the expiration date approaches. The options Greek theta is a measure of an option's time decay.
If you trade options, you're always dealing with time decay, so you need to understand how it works and impacts your positions.
Time decay’s impact on option positions
Options time decay is not linear. As the contract nears expiration, time decay accelerates, especially for near-the-money options.
The longer the time until an options contract expires, the greater the opportunity for the underlying security’s price to move, so the contract has more time value.
An option contract is constantly losing value, however. You're essentially paying theta to hold the position if you buy an option. The closer the option gets to expiration, the faster it will decay. That's why choosing an expiration date that gives you enough time to realize your profit goals is important.
If you sell an option, you're receiving theta. This means that as time goes on, the option will lose value, and your short position will benefit. The closer the option gets to expiration, the faster it will decay
Extrinsic value & the Greeks
Time decay and implied volatility make up an option’s extrinsic value. Extrinsic value, along with intrinsic value, determines an option's price. Because time and volatility are everchanging, these values are not constant.
Typically, the more time that remains until expiration, the higher the option's extrinsic value. Investors will pay a higher premium for additional time since the contract will have longer to achieve profitability from a favorable move in the underlying asset.
Extrinsic value is greatest when an options contract is at-the-money. Extrinsic value decreases as options contracts get deeper in-the-money, deeper out-of-the-money, or closer to expiration.