Time Decay

Understanding Time Decay in Options

Time decay, commonly called theta, is the decline in an option’s value as its expiration date approaches. Because options have a limited lifetime, the portion of their premium attributable to time — the time value or extrinsic value — decreases over time. This process is continuous and irreversible: once time passes, the potential for profit from that remaining time is lost.

Key points

• Time decay (theta) reduces an option’s extrinsic value as expiration approaches.
• Decay accelerates as expiration nears, often becoming most pronounced in the final 30 days.
• At-the-money (ATM) and out-of-the-money (OTM) options tend to lose value faster because their premium is mostly time value.
• Intrinsic value (if any) is not affected by time decay; only extrinsic value declines.

Components of an option’s value

An option premium consists of:
* Intrinsic value — the built-in profit if exercised now (underlying price minus strike for calls, or vice versa for puts). This component is unaffected by time.
* Extrinsic value (time value) — the portion that reflects time remaining and uncertainty (volatility). Time decay eats away at this component.

Theta is one of the options Greeks (alongside delta, gamma, vega, rho) used to measure how price and risk change. Theta is expressed as the amount an option’s price is expected to decline per day, all else equal, and is always negative for long option positions.

How moneyness affects time decay

“Moneyness” describes whether an option is in-the-money (ITM), at-the-money (ATM), or out-of-the-money (OTM):
* ATM options: often have the largest time value, so they experience substantial time decay.
* OTM options: mostly time value and can decay quickly as expiration approaches because the chance of becoming ITM diminishes.
* ITM options: retain intrinsic value, so the impact of time decay on total premium is smaller (though extrinsic value still decays).

Factors that influence time decay

• Time to expiration — more time means slower decay; less time means faster decay.
• Moneyness — ATM and OTM options generally have higher theta (faster decay) than deep ITM options.
• Volatility — higher implied volatility increases extrinsic value and can partially offset time decay; lower volatility reduces time value.
• Interest rates and dividends can have minor effects but are secondary to time and volatility.

Pros and cons for traders

Pros
* Time decay is slow early in an option’s life, giving long-option buyers more time for the underlying to move.
* Option sellers can profit from time decay by collecting premium as extrinsic value erodes.
* Theta helps traders estimate the daily erosion of option value and manage position timing.

Cons
* Time decay accelerates as expiration nears and can rapidly erode long-option positions.
* It occurs regardless of underlying price movement — a long option can lose value even when the underlying is unchanged.
* Predicting the exact rate of decay can be complex because it interacts with volatility and price movement.

Simple example

A call option with a $20 strike that expires in two months might trade for $2. The same strike with only one week until expiration might trade for $0.50. Both reflect the same intrinsic potential, but the shorter-dated option has much less extrinsic value because there’s far less time for the underlying to move favorably.

Practical takeaways

• Buyers of options must overcome time decay — the underlying needs to move enough and quickly enough to offset theta.
• Sellers (writers) of options generally benefit from theta because extrinsic value decays in their favor.
• Manage exposure by choosing expirations and strategies (e.g., spreads, rolling) that align with your time horizon and view on volatility.
• Monitor theta alongside other Greeks (delta, vega) to understand how price, volatility, and time interact.

Time decay is a fundamental concept in options trading. Understanding how it works and how it interacts with moneyness and volatility helps traders make better choices about contract selection, timing, and strategy.