Time decay in options is the rate at which the time declines the value of any option. It is important to know that time decay is exponential. It accelerates as the date of expiry comes closer. The speed of acceleration is completely related to how far in the money the option's strike price is. If the investor has an in-the-money option, they will want to pay closer attention to the date of expiry and sell the option as soon as possible to have the best value related to the time decay in options. Finding out how time decay works in options can be a little complicated because it takes a little bit of understanding. But finding out what it is, what it represents, and how it affects the overall option prices is vital if the investor wants to succeed in trading options in the financial markets. Our article will help you find out more about how time decay works in options. You will also find out how the price of any option in the financial markets changes as the date of expiry draws near. You will find out about the factors that can influence how swiftly an option loses its value when it comes closer to expiry.

What is Time Decay in Options?

Time decay in options is the expected decline in the price of an option as the date of expiry comes closer. The time decay leads to a growth in the probability of any option expiring out-of-the-money. The time decay leads to the erosion in the prices of the option. So, the traders must be wary when trading in long-term and short-term options. Usually, time decay in options refers to the decline in the premium or price of an option over time until the moment when it expires completely worthless. The time decay is a function of the interest rates, the time remaining until the date of expiry, and the volatility. Most of the traders in the financial markets are quite familiar with the decay in time. But many new traders do not understand that the time value declines in reverse fashion. As the date of expiry comes closer, the value of time slowly grows because of the increasing probability of any option reaching the strike price before the expiration.

The time decay is found by removing the price of the stock from the strike price of the options. It is then divided by the number of days remaining until expiration. For instance, a stock may be trading at nine dollars, and you may be thinking of purchasing a call option with the strike price of ten dollars. Then this formula would result in nearly eight cents. This means that the value of the options would decline by nearly eight cents for each day that reaches the date of expiry. The time decay in options is affected by a lot of factors. This includes the tick value and the price of the shares. The higher the share price, the slower the rate of time decay will be. This is because there is less money left on the table if the shares move in favor of the trader after they purchase the call option. The smaller the value of the tick or the size of each move, the faster time decay will happen because it is easier for the shares.

How Does Time Decay Work in Options?

The decay in time of any option contract declines over the life of the contract. For the call options that give the person the right to purchase, the decay in time negatively impacts the price of the call. For the put options that give the person the right to sell, the time decay positively impacts the put price. The decay in time is an ongoing and genuine challenge for all the options traders. But many newbie options traders are not aware of the time decay factor until it becomes too late. The traders can overlook the decay in time because the effect on the prices of options is not instant. The decay in time can be seen the most in the options with a shorter expiry frame. But the impact of decay in time is present in that scenario also. This assists in explaining why many of the seasoned traders in options try to sell rather than purchase the options.

On the contrary, the time decays are usually functioning against the investors who tend to hold on to the options for long positions. This needs them to keep adjusting their strategies not to get mired in losses because of high decay in value because of time. It can be seen as the cost of keeping a long position in any option over time. The lengthier the time for which an option is held, the bigger the degree of time decay that is going to happen. You should always remember that the time decay in options functions in favor of option sellers involved in the short-term rather than the long-term.

How Does Time Decay Work in Options to Affect Pricing?

The decay in time is the most important determinant of the prices of options. Any modification in the price of any options because of a change in the underlying security price is known as the intrinsic value. The time premium of any option is the amount by which the cost is more than the intrinsic value. It is nearly always negative. This means that the time premium position of any option price is seen to be below zero. This means that any option will decline the time premium as it comes close to expiration. The decay in time becomes swifter when the option is near the expiration. For instance, an at-the-money call option will lose its extrinsic value within a month until expiration in only a couple of weeks. The effects become a lot more pronounced than options, with only some days until expiration, which are seen to be worthless. They have no extrinsic value as they are already quite close to being worthless. The prices keep changing as the investors and traders in the financial markets lose and gain confidence in whether some events will happen in the markets.

They may believe that it is making much better business sense to either take the gains on the existing positions or hedge them instead of letting those positions go through their entire course. This usually means that the time value position of the premium of any option declines due to the decay in time and increases the intrinsic value. The overall effect of time decay is more in the last month before the date of expiration because an option has a more extrinsic value than what its passage can erase. For most of the options in the markets, the passing of time leads to a decline in their value. As the options get nearer to the expiration date, it becomes a lot less valuable. This is major because of a couple of reasons. The options have less time to go until the date of expiration. Also, the more the option is in-the-money, the more vital influence time decay will have on the price. The time decay increases for the in-the-money options. So, it is not very beneficial to elongate the period of holding for these options contracts unless the person has some strategy in mind.

The effects of these factors are also compounded. This leads to a swiftly declining value for the option. The rate at which the value of nay options decreases gathers speed as the date of expiry nears. This means that there is going to be more risk with holding on to the trade than when the trader had opened the position initially. 

Conclusion

How does time decay work in options? All the options instruments usually come with a date of expiry by which the instruments must be exercised, or they will expire. There are also other elements that decide what is going to be the value of any option instrument. This determined value is called the premium that the option buyer has to pay. We hope we have helped you determine how time decay works in options.