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What Is Time Decay?

If you’re trading options, you must consider time decay. Although there are a lot of similarities between trading options and trading stocks, a stock trader does not need to concern themselves with time decay the same way an options trader does. You may have heard the term before, but if not, let’s start with the definition before we start unpacking it further.

By definition, time decay refers to how the price of an option changes as the option approaches its expiration date. More specifically, time decay is the erosion of value within the options contract as time passes and nears the option expiration date. 

How Time Decay Works

The best way to understand time decay is to visualize a chart. On the Y Axis – the vertical axis, imagine the price of the option. The X Axis, or horizontal axis, will represent the time. The far right of the X axis will be the options expiration date. 

With each trading day that passes, the price will begin to trend to 0. The closer you get to the expiration date, the more dramatic the erosion becomes. 

How is Time Decay Measured?

Time decay is measured by one of the options Greeks, known as Theta. The mathematical formula involved in calculating time decay is complex. On a high level, a trader must understand time decay does not erode by the same value each day. Theta is a slope, and that slope becomes more steep in the days/weeks closest to the expiration date. 

Why is Time Decay Important?

Both time decay and time value are considered important fundamentals of options trading because these measurements help determine the likelihood of the option trade being profitable. If there is less likelihood of the option becoming profitable, the option will lose value and the trader will lose money if the option is exercised. 

Why Does Time Decay Happen?

The reason for time decay is quite simple when you look past the math formulas. An option gets its value on price movements and implied volatility. The less time an option has left before expiring, the less likely it is to derive intrinsic value from the option. As each day passes, the probability that the share price will hit the strike price becomes less probable, which ultimately drives down the price someone is willing to pay.  

What is an Example of Time Decay?

To better understand time decay, let’s visit this example. 

Imagine an investor wants to buy a call option with a strike price of $50 and 60 days from the current trading day. Remember, you always pay a premium to buy any option contract, and in this case, the premium was $5 a share. Following this example, the options trader would need the price of the option to rise to at least $55 to break even ($5 premium + $50 per share). 

If there is only one week left before expiration, and the share price is trading at $51 for example, it is highly unlikely the stock will rise to $55 over the next week. If someone wanted to buy this options contract with a week left, the premium would not be $5 per share as it is unlikely the stock price will rise by $4 in the next five days. The premium may now be $0.25 or $0.50 per share. 

The option must have intrinsic value for the trade to be profitable, and with such little time left in the contract before expiration, the chances of that happening is few and far between. 

What is Time Value?

The time value of an option is the amount of time remaining within an options contract before it expires. As shown above, the more time available within the options contract, the more valuable it becomes. As time progresses and nears expiration, the probability of reaching the strike price declines, and so does the value of the option. Time value factors in the options extrinsic value, in addition to the implied volatility. 

What is Time Value of Money?

It’s important not to confuse time value with the time value of money formula. The time value of money is a financial formula that shows how money loses its purchasing power over time.

To better understand the time value of money, consider this example: 25 years ago a candy bar cost $1. If you had $100, you could buy 100 candy bars. In today’s age, a candy bar is $1.25 per bar. If you had $100, you could buy 80 candy bars. 

Prices of goods and services increase over time, known as inflation. Unless your money appreciates at the same rate as inflation, your money technically loses its purchasing power over the years. The same amount of money, $100 in the example, does not buy the same amount of products (candy bars) in the present day.  

What is the Difference Between Time Value and Time Decay?

Time decay represents how an option loses money as it nears the expiration date. Time value puts a valuation on the time left within an options contract to arrive at the contract’s extrinsic value. Contracts with longer periods of time before expiration will demand a greater premium. 

How Does Time Decay Affect Option Traders?

Time decay is present in option trading, but it’s not a concern for stock traders. In theory, someone can own a specific stock for any duration of time… from a few seconds, to one day, even 50+ years!

Options do not have that luxury. When you’re buying an option, you’re buying something that has an expiration date. You’re betting that the price of the stock will be at X price by X date. 

As the expiration date approaches, the probability of the option reaching the target price declines, therefore the option value declines, eventually hitting $0. 

What is Intrinsic Value?

Intrinsic value measures what an asset is worth if you were to exercise or strike the contract right now. Let’s visit a call option example. 

If you had a call option with a strike price of $25, and the current share price is $30, you have $5 of intrinsic value in that contract. You could exercise the contract right now, own the shares at $25, and sell them on the open market for $30, resulting in a $5 per share profit. 

A put option has intrinsic value when the stock is currently trading below the strike price whereas call options have intrinsic value when the stock is trading above the strike price. 

What is Extrinsic Value?

The easiest way to remember extrinsic value is to look at the first three letters, “ext.” Extrinsic value factors on extra variables, such as the time value and the implied volatility. 

Extrinsic value is the delta between the current market price of an option and the known intrinsic price. The extrinsic value fluctuates with market volatility. 

What is “Moneyness?”

“Moneyness” lets a trader know if exercising the contract will result in a profit. “Moneyness” is broken down into 3 categories which are commonly discussed with options trading. 

  • In the Money, or ITM, means if the trader were to sell the contract at the current price, the trader would make money.
  • Out of the Money, or OTM, means the trader would lose money if they exercised the contract. 
  • At the Money, or ATM, simply means the trader would break even if they were to exercise their contract. 

Tip of the Iceberg 

It’s without question, option trading can be rather complex. Between the various terminologies and definitions it can feel overwhelming. Time decay and time value is just the tip of the iceberg. The tip is very important, but there’s quite a bit of information below the surface that you’ll need to learn before you should consider trading options. 

Working with a Financial Advisor can help make sense of all the market noise and variables. Financial Advisors are essentially personal trainers for your money. They’ll listen to your goals, take an inventory of your current assets, and help craft a plan to help you reach your goals. You’ll still have to work hard, but they can guide you in the right direction.  

If you’re looking to live a more financially balanced life, consider working with a Financial Advisor. It never hurts to get a second opinion, or to have an unbiased pair of eyes help you create a financial plan.