Time Decay Options

Time Decay Options Explained

10 min read

What do time decay options mean? They measure the rate of decline of an options contract with time. Options contracts are decaying assets that have an expiration date. Time eats away at an options contract each day that goes by. It is a widely discussed fact that most options contracts expire worthless. Below, we’ll discuss how decay plays a role in bringing down the value of an options contract.

Time decay options measure time’s risk on an options contract. Time value is important because options expire. Options lose their value as the expiration date approaches. Simply put, theta measures how much value an option loses daily as it gets closer to the expiration date. This is why an option can sometimes be called a wasting asset. With each passing day, value leaves.

This article will look at time decay options and their meaning. Investopedia defines it as the ratio of an option’s price change to the decrease in time to expiration. Since options waste assets, their value declines over time.

Stock options contracts give the buyer the right but not the obligation to buy or sell at a specific price. A bullish play is a call. A bearish play is a put.

The purpose of an options contract is to predict how the stock will move. You can buy an option lower than the stock and sell at a higher value for a profit. Trading options is a great way to make a living.

A lot of options buyers, especially new ones, buy calls and puts. Calls and puts have limited risk and unlimited profit potential. But in doing this, you’re missing out on many benefits of options trading.

Time Decay Options Expiration

You can use time decay to your advantage with options. It affects the value of the options contract. As the expiration date of an option approaches, it’s easier to predict the value of the contract. Options contract sellers collect time value premiums, which the buyer of the option pays.

Options sellers can benefit from the time passing even if the contract is not moving. Time will affect profits when an option is in or out of the money.

Time Decay Options and the Greeks

Options have something known as The Greeks. Let’s consider them an options trading fraternity. The Greeks are statistical values that measure risk. They focus on the topic of time decay. Understanding it is important when selling options; this is a great way to use time to your advantage.

Time Decay Options Example

Enemy Known as Father Time

Father Time comes for all of us. When long on an option, the time decay will be negative. That is when you need implied volatility and the stock price to change.

Suppose they do not get executed and are not in the money by expiration. This is known as the option expiring worthless. Out-of-the-money options are typically the options expiring worthless.

When an option is out of the money for a call, the strike price is higher than the stock price. When a put option is out of the money, its strike price is lower than the stock price.

You’re looking at the option time decay curve. Intrinsic value + extrinsic value = option’s price. Break out the option calculator! Time decay falls with the passing of days, affecting the outcome of the option price.

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Buy or Sell Options Time Decay?

When you buy a time decay option, you’re on the hook for the decay. There are time decay options strategies you can use. All options contracts begin equal.

It’s ok to give yourself time. If you purchase an option with an expiration date that is a ways away, you can sell it much sooner at a profit.

Theta is low when an options contract with a long expiration date isn’t going to move fast. The decay moves faster, and the closer to expiration an option gets.

Now, if you sold (which means you’re short) an option, a decrease in time is a good thing. The option is less valuable, so it’s cheaper to buy back at a lower price (closing the position).

As stated earlier, the seller benefits from time decay options. If you short a stock, you’re borrowing shares from your broker to “buy back” when you cover the position. You could buy a put, and time decay can be a negative factor. Or you can sell a put and let the time decay work for you.

Rate of Time Decay Is Not Linear

It’s important to understand that the rate of time decay doesn’t happen at a constant rate. It speeds up as time goes on.

For example, the decay rate is relatively slow if there are still 150 days until expiration. However, the decay rate is faster, with fewer days left until expiration, such as 40 or 50 days. Time decay significantly impacts the extrinsic value when there is one month or less until expiration. As a general rule, the closer the expiration date, the faster the rate of time decay.

Profiting From Options Time Decay

Profiting from option time decay involves strategically trading options to take advantage of time’s diminishing value as the option expires.

When you sell options, whether it’s by writing (selling) call options or put options, you can benefit from time decay. As time passes, the option’s value erodes, resulting in a decrease in its premium. By selling options with a shorter time remaining until expiration, you can (hopefully) capture the decay in the option’s value.

Avoiding Options Time Decay

One way of avoiding or at least reducing the decay in an options contract would be to buy or sell ones with a longer expiry. This will give you time to make gains and reduce the probability of losses. Secondly, you could buy and sell simultaneously to compensate for losses. 

Option Time Decay Strategies

1. Option Spreads

You can simultaneously neutralize the negative effect of time decay on buying options by writing options. Many trades involve creating options spreads, where you buy specific contracts and then contract 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 you bought could return a profit if the stock moves favorably, but the loss of extrinsic value might reduce that profit due to time decay. However, you would also benefit from the eroding extrinsic value in the contacts you have written.

2. Vertical Spreads

Vertical spreads involve buying and selling options of the same type (calls or puts) but with different strike prices simultaneously. By using spreads, traders can limit their risk while capturing some of the decay in the sold option.

3. Short Strangle or Short Straddle

These strategies involve selling both a call option and a put option simultaneously. Traders aim to profit from the decline in the options’ value due to time decay as long as the underlying stock remains within a specific price range. 

If you want to learn more, check out our blog post on Options Straddles Explained.

4. Iron Condor

An iron condor strategy combines a bull put spread and a bear call spread. This strategy aims to profit from time decay if the underlying stock price remains within a specific range.

Key Takeaways

  • Time decay is the reduction in value of an options contract as its expiration date approaches. 
  • The higher the decay, the faster your options are losing value.
  • The rate of time decay is not consistent. As the expiration date approaches, the time decay rate accelerates. 
  • At-the-money (ATM) options have the highest rate of time decay.
  • One way to avoid or at least reduce the decay in an options contract is to buy or sell ones with a longer expiration.

Final Thoughts: Time Decay Options

It’s important to note that while trading options to benefit from time decay can be a viable strategy, it involves risks. Losses can occur if the underlying stock price moves significantly or if there is an unexpected change in market conditions.

It can seem scary. There’s a lot of information to take in, which can be overwhelming. Make sure that you practice paper trading options. There are many strategies you can follow. The good thing is that there are a lot of moving parts with options. The more you study, the more prepared you’ll be when trading options. If you need more help, take our options trading course.

Frequently Asked Questions

Every option has a different rate of decay due to loss of time value. The delta of an option contract measures the speed. Options are decaying assets so each day that passes the more the option decays.

Time decay does not work in your favor being an options buyer because they are decaying assets. Becoming an options seller puts the trading odds in your favor because time is on your side as an option seller.

With all things being equal, at-the-money (ATM) options have the highest rate of time decay. As options move either out of the money (OTM) or in the money (ITM), the rate of time decay drops and goes toward zero. Also, shorter-term options decay faster than longer-term options. The decay rate accelerates as an option gets closer to its expiration date.

Time decay in options measures the risk of time on an options contract.

You can profit from time decay in options through a few strategies, such as shorting. Likewise, if you're short an option, time is on your side because your theta value is positive.

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