Time Decay in Options Trading

Time Decay of Options Explained

As explained above, time decay is the erosion of the value of options as time progresses. To explain further, we must look at how the price of an option is effectively made up of two separate components: intrinsic value and extrinsic value.

Intrinsic value is relatively simple to calculate because it essentially represents the theoretical built in profit of an options contract at a specific point in time. For example, a call with a strike price of $20 on an underlying security that was trading at $25 would have an intrinsic value of $5. Technically it could be exercised to buy the underlying security at $20, which could then be sold at the market price of $25 for a $5 profit. This $5 profit represents the intrinsic value of the contract. If the underlying security was trading at $20 or below, then the call would have no built in profit and therefore no intrinsic value.

Extrinsic value is slightly more complex, because it's less tangible than intrinsic value. In some ways, the extrinsic value is really the true cost of owning an options contract, because it's effectively the money that you pay for the possibility of being able to benefit from price movements in the underlying security. For example, if you bought at the money calls with a strike price of $30 on an underlying security that was trading at $30 there would be no intrinsic value, only extrinsic value. If the cost of each contract was $2, then you would basically be paying $2 for the right to take advantage of any upward price movement of the underlying security.

There are a number of factors that affect extrinsic value, and time is one of those factors. In fact, extrinsic value is often referred to as time value because time is considered to be the most important factor. Because contracts have a fixed expiration date, there' always a limited amount of time for the price of the underlying security to move favorably for the holder. The longer there is until expiration date, the more chance there is for the underlying security to move and therefore the more chance for the holder to make a profit.

As such, the amount of time remaining until expiration date usually has a significant impact on extrinsic value. The general rule is that the more time there is left, the higher the extrinsic value. As the expiration date draws closer, the extrinsic value gets lower and that's basically time decay in action.

Why Time Decay Happens

We can see then that time decay is basically the process by which extrinsic value diminishes as the expiration date gets nearer. This is really quite logical, because it makes sense that an option would be less valuable if there is less time for the relevant underlying security to move in price. Consider the example above where we mentioned at the money calls with a strike price of $30 and a cost of $2. If you were buying those calls, then you would need the underlying security to move to $32 by expiration just to cover the cost of buying them. If they had a long time until expiration, then this might represent a sound investment.

However if there was only a few days until expiration and the security was still at $30, then the calls would be probably be trading at much lower than $2 as there would be much less chance of the security moving enough in just a few days. The extrinsic value of $2 would have reduced significantly and, with no intrinsic value involved, the price of the calls would also have decreased accordingly.

If you held on to those calls all the way until expiration and the underlying security still remained at $30, then they would expire worthless. This is essentially how and why time decay happens, and it's also why options are considered to be depreciating assets.

Rate of Time Decay

It should be noted that time decay isn't a linear function, meaning it doesn't happen at a fixed rate. If an options contract has, say, 150 days until expiry, then the extrinsic value doesn't diminish at the same rate for each of those 150 days. With 150 days to go until expiration, the rate will be quite slow, whereas with only 40 or 50 days to go the rate will be faster. Once there is less than one month to go, time decay will typically have much more impact on the extrinsic value. Basically, the closer the expiration date, the faster the rate of time decay.

The rate of time decay is measured by one of the options Greeks, Theta. The Theta value of an options contract theoretically defines the rate at which its price will decline on a daily basis. For example, the price of a contract with a Theta value of -0.03 would be expected to fall by approximately $0.03 each day.

You can find out the Theta value of most contracts by studying the appropriate options chain, but you should be aware that it's only a theoretical value and not a guarantee of the rate of time decay. It can be useful to help with predicting the effect of time decay, but shouldn't necessarily be relied upon. Because the rate accelerates as the expiration date gets closer to expiration, the Theta value will change accordingly.

How Time Decay Effects Options Traders

The main effect that time decay has on traders is that the extrinsic value of any contracts that they own is likely to be diminishing for every day they own them. For traders that simply buy calls and puts with a view to holding them until expiration, time decay isn't really an issue: even though it will still of course be in effect.

The idea of holding options until expiry is that, although the extrinsic value will have completely eroded by that point, the underlying security will move favorably enough to make up for the loss of the extrinsic value and they still return a profit. As a simple example, if you bought at the money calls (with the strike price equal to the current trading price of the underlying security) for $1, then as long as the underlying security went up by more than $1 in price then you will make a profit.

However, for traders that are buying contracts and planning to close their position prior to expiration, time decay really does need to be taken into consideration for each and every trade. In order to close a position early and make a profit, the intrinsic value of any options bought must increase by an amount larger than the effect of time decay.

For example, if you bought contracts and the intrinsic value went up by $1 but the time decay effect reduced the extrinsic value by $1.20, then you would be in a losing position.

It's obvious that to make money you need the price of the contracts you buy to go up in value before you sell them. However just because you own calls on an underlying security that's going up in value, or own puts on an underlying security that is going down in value, it doesn't necessarily mean that those contracts are actually going up in price because time decay could be effectively wipe out any gains from the increase in the intrinsic value.

Essentially, it's absolutely vital that you take into account the effect of time decay on the price of options when you are planning your entry and exit points for all your trades.

It's also possible to use time decay to your advantage, or at least neutralize its effect. Although it has a negative effect on the holders of options contracts, it has a positive effect on the writers of them. When you write options contracts, the extrinsic value of them at the time of writing them is basically your upfront profit. If their intrinsic value doesn't increase between the point of writing them and the point of them expiring, then you will retain that profit.

All the extrinsic value will have eroded due to time decay, meaning you have actually benefited from the process. Even if the intrinsic value does increase, that will at least be offset in part by the reduction in extrinsic value. Although you may still make a loss, the effects of time decay will at least minimize that loss in some way.

You can neutralize the negative effect of time decay on buying options by also writing options at the same time. Many trades involve creating options spreads, where you buy specific contracts and then contracts options based on the same underlying security. For example, you could buy in the money calls (with some intrinsic value) on a particular stock and simultaneously write out of the money calls (with no intrinsic value) on the same stock.

The contracts that you have bought could return a profit if the stock moves favorably, but that profit might be reduced by the loss of extrinsic value due to time decay. However, you would also be benefitting from the eroding extrinsic value in the contacts that you have written.

All these examples simplify the effect of time decay, but they also show how the basic principle works. It's clearly a very important aspect of trading that can both positively and negatively affect your trades. Understanding how it works and how it impacts your potential profits is the key to being successful.