Definition: Time Decay is the inclination for options to decrease in worth as the expiration date draws near. The extent of the time decay is inversely connected to the changeability of that option. Time Decay, also referenced to as theta, may be measured by watching the rate of decrease in the amount of an option over time.
Why does it happen?
Options have an intrinsic and an extrinsic worth. As time expires and the finish date of the option approaches, the value of the option loses its extrinsic value and gets near to its intrinsic value.
For instance, the worth associated with trading diminishes with time, meanwhile the value associated with the actual difference between the strike price and the underlying stock price becomes more noticeable.
The more often the option is traded, the less is the result of time decay as market forces maintain the extrinsic value. Also a thinly traded option is subject to considerable time decay as the extrinsic value rapidly dissipates due to a lack of demand.
Take for instance, AAPL stock price stays constant at $335 for 10 days before the options expiration date.
Price of $340 Call Option 10 days before expiration: $1.05
Price of $340 Call Option 5 days before expiration: $0.50
Price of $340 Call Option on day of expiration: $0.00
The intrinsic value of the call option was $0.00 as it was out of the money throughout the 10 days. Because of supply and demand of the option, the extrinsic value gave a price to the option. As the expiration got closer, the price of the option fell short of its extrinsic value and moved towards its intrinsic value.
Long and Short of Time Decay:
Time Decay can be a useful tool for Options Writers (shorts).
If you can estimate with the help of Theta what the rate of decay of an option is, it is possible to make good profits from the difference in the premium received and premium paid at or before expiration.
Generally, time decay begins gathering momentum around 30-60 days before the expiration date of an option.
Contrary to holding options for a long period of time, especially out of the money, one needs to be good at predicting where the price of the underlying stock will close at the date of expiration.
The investor must realize that because of time decay, the price of their option will not move as much as it does the prior day.
Options lose value every day the stock price does not go in the favor of their option.
Time Decay increases the chance of a loss in option price daily for a long option holder, while decreasing the risk of a price increase for a writer of an option. Time decay is best measured via the Greek, Theta.