What is Time Decay?

Theta or time decay is defined as the loss in the price of an options contract as it nears expiration. It is the pace at which the premium (the amount paid for the option) of an option decreases over time just as a result of time passing. It happens irrespective of the movement in value of the underlying asset and is an intrinsic feature of options.

It also implies that time decay has an impact on the premium paid by the option holder which therefore indicates that the closer an option gets to its expiry date, the less value it has.

 

How Does Time Decay Work?

Options have a finite lifespan and they have attached time value which is not only a function of the change in the price of the underlying asset but also the time that is available before the option expires. The time decay increases in the final days of a longer period because of the delta issue, and this is why options lose their value quickly at the last few weeks of expiration.

For instance, if you have purchased the option that is set to expire in 90 days, you can hardly notice the effects of time decay for the initial several weeks. Nonetheless, starting from the last 30 days, the rate of decay sharpens significantly, and the option depreciation is even faster. This is particularly relevant for options to traders with long positions as time is a chief enemy in options trading.

 

Impact of Time Decay on Options Pricing

Time decay mainly affects the second component of the option price which is the part that depends on everything that is other than the price of the underlying asset such as volatility and time to expiration. It is highlighted that the converted value derived solely from the difference in the current underlying asset’s price by the option’s price is not affected by time skew.

Here’s how time decay affects different types of options:

• Call Options: Over time, the value of call options and put options which are the primary building blocks for any trading strategy that involves options dwindle in their extrinsic value and this might not be good news for traders who hold long call positions. 
• Put Options: Likewise, put option value being of an extrinsic nature, it reduces with time and affects the trader, who has bought put options.

 

Factors Influencing Time Decay

The key factors that influence time decay are as follows:

• Time to Expiration: The first one, as mentioned earlier, is the proximity of the option to its expiration time. It causes deterioration at a faster pace the closer it gets to the targeted level.
• Volatility: Debit options with higher volatility will take longer to decay since the likelihood of a price change is adequate to offset the time lost.
• Interest Rates: However, even small changes in interest rates affect the rate of time decay especially for long-term options.

 

Open Free Demat Account and Start Trading

It is vital for every investor and traders to understand the demat account meaning in order to participate in the stock market. A Demat account meaning refers to an account that helps one trade and transacts with securities held in a digital format.

A regular Demat account, however, has charges and costs associated with it that minimize your returns. This is why you must open a free demat account in order to maximize your returns.

 

Conclusion

Time decay is an unavoidable element of options trading that plays a significant role in determining the value of options over time. By understanding how time decay works, you can better navigate the market, strategize your trades, and minimize potential losses. Whether you’re an options seller looking to capitalize on time decay or an options buyer trying to mitigate its impact, knowing the mechanics of time decay is key to successful trading.