Time decay in options is a concept that you certainly don’t want to ignore. The whole concept is rather intuitive (the closer you get to the expiry date, the more value your option loses), but there are some nuances that can greatly impact your trading strategy. In this article, you’ll learn what time decay in options is, how option decay works, whether you need to know the option time decay formula to trade, why it accelerates near expiration, and how it affects your strategy.
Key takeaways
- Time decay in options is the gradual reduction in the value of options as their expiration approaches. This effect can be bad for you if you bought options, but it works in your favor if you are an option seller.
- Time decay accelerates as the expiration date gets closer, especially for at-the-money options.
What Is Time Decay in Options?
Time decay in options refers to the steady decrease in an option’s value as it approaches its expiration date. This happens because the time-value portion of the option’s premium—driven by a concept called theta—becomes smaller every day. Simply put, the closer we get to expiration, the less time there is for the option to move in a profitable direction.
Theta represents the rate at which options lose value due to time passing. Here’s where the “option time decay formula” comes in. While the formula itself can get a little technical, its main takeaway is this: time decay doesn’t happen at a constant rate. This is the typical chart of an option’s time decay:
Notice that this is not a straight line. In fact, options, especially those at-the-money, lose value more rapidly as expiration day nears—a phenomenon every trader should pay attention to. As you can see, you don’t need to know the option time decay formula to understand how this phenomenon works.
Some key points about options time decay:
- When does theta decay accelerate? The effect of time decay accelerates as expiration approaches, particularly for at-the-money options.
- Out-of-the-money options with little intrinsic value may end up worthless by expiration due to time decay.
- The loss in value occurs exponentially, not linearly. This is because the option time decay formula incorporates a rapid acceleration of the time value decrease during the last hours preceding a contract expiration.
Is Time Decay in Options Good or Bad for You?
Option decay can either help you make a profit or ruin your trade. Whether it’s good or bad depends entirely on your role—are you an options buyer or seller? Here’s a table summarizing how time decay affects your options trades:
| Role | Impact of Time Decay | Key Takeaway |
| Options Buyer | Time decay reduces the option’s value over time, especially as expiration nears, potentially causing losses. | Time decay is a challenge; act quickly to avoid significant value erosion. |
| Options Seller | Time decay erodes the premium, benefiting the seller as the likelihood of keeping the premium as profit increases. | Time decay works in your favor; maximize profit through smart selling strategies. |
- For options buyers, time decay in options is a constant challenge. As days pass, the option’s value diminishes because of the gradual erosion of its time premium. Even if the price of the underlying asset is moving in the right direction, this decay can eat into your profits or, worse, make your trade worthless. Options time decay accelerates as expiration nears, leaving buyers with little room for recovery if the option doesn’t move into profitable territory.
- For options sellers, it’s a completely different story. Option decay works in their favor. Every day that passes without much movement in the underlying asset increases the seller’s chances of keeping the premium as profit. Seller-friendly strategies, like selling at-the-money options, rely on the sharp acceleration of theta decay leading up to the expiration date.
Understanding Time Decay in Options with the Intrinsic and Extrinsic Values
The best way to understand how time decay works is to know that the value of an option is actually the sum of its intrinsic and extrinsic values. These two components play a critical role in determining the price of an option and how it changes over time.
Intrinsic Value
Intrinsic value is straightforward—it’s the actual profit you could make if the option were exercised immediately. It’s calculated as the difference between the current market price of the underlying asset and the strike price.
For example, if a stock is trading at $50 and your call option (which you may find on a market screener for options like ours) has a strike price of $40, the intrinsic value is $10. If the stock price is at or below the strike price for a call option, there’s no intrinsic value—it’s considered “out of the money.” Intrinsic value depends entirely on market movement, while the strike price remains fixed.
Extrinsic Value and Time Decay in Options
Extrinsic value, however, is less tangible. It represents the added cost traders are willing to pay for the time left until the option’s expiration and the potential for profitable movement. This value decreases as the expiration date approaches due to time decay. Early on, options lose extrinsic value gradually, but as expiration nears—particularly in the last 30 days—the theta decay accelerates sharply. This is when theta decay becomes more noticeable and directly affects the option’s premium.
Some key points about extrinsic value and time decay in options:
- Longer durations until expiration mean more extrinsic value.
- Time decay erodes extrinsic value faster in the final weeks before expiration.
- This accelerated decay can catch unprepared traders off guard.
Why Time Decay in Options Matters
In short, if we were to read about option decay for the first time, we’d want an experienced trader to tell us:
- Traders need to understand the relationship between intrinsic and extrinsic values.
- Time decay in options directly impacts trading strategies.
- Options nearing expiration lose significant value if they are not profitable (i.e., if they are “out of the money”). This leaves less room for recovery as the likelihood of the option to move from out of the money to in the money decreases.
Moneyness and Time Decay in Options
There is one last thing we want to share with you on the topic of time decay in options. To understand how time decay affects your trades, you need to grasp moneyness—a term that describes whether an option is profitable based on its intrinsic value. Moneyness is broken into three categories, and each reacts differently to time decay.
Simply put, the table below summarizes the concept of time decay in options vs moneyness in options:
| Moneyness | Intrinsic Value | Reaction to Time Decay |
| In-the-Money (ITM) | Yes, the option has intrinsic value. | Holds value better as expiration nears. Loses premium but retains intrinsic value. |
| At-the-Money (ATM) | No intrinsic value. The option only has extrinsic value. | Most sensitive to time decay. Premium drops quickly, especially near expiration. |
| Out-of-the-Money (OTM) | No intrinsic value. | Highly vulnerable to time decay. Often loses all value as expiration approaches. |
In-the-Money (ITM) Options
ITM options already have intrinsic value, meaning they have built-in profitability. For instance, if a stock trades at $50 and you own a call option with a $40 strike price, the intrinsic value is $10. These options hold up better as expiration nears because their intrinsic value isn’t heavily affected by time decay. They may lose some premium, but they retain value based on how “in the money” they are.
Quick Example: You buy a call option with a $30 strike price for a stock currently at $45. This option is ITM with $15 of intrinsic value.
At-the-Money (ATM) Options
ATM options are the most sensitive to time decay. These options don’t carry intrinsic value—only extrinsic value, which measures potential profitability. Time decay steadily eats away at this extrinsic value. Every passing day causes ATM premiums to drop, especially as the expiration date draws closer.
Quick Example: A stock is trading at $50, and you hold a call option with a $50 strike price. This ATM option has no intrinsic value and relies solely on the stock moving higher soon for profitability.
Out-of-the-Money (OTM) Options
OTM options also have no intrinsic value. Their small premiums rely entirely on time and the possibility of converting into ITM options. This makes them highly vulnerable to time decay. As expiration nears, the likelihood of OTM options becoming profitable dwindles, and their value drops rapidly. Notice that theta decay accelerates so much that it will normally leave OTM options to expire worthless.
Quick Example: A stock is trading at $40, and you own a call option with a $50 strike price. Since the stock price is below the strike price, this OTM option has no intrinsic value and depends on a significant stock rally to gain value.
What You Should Remember on Time Decay and Moneyness
- All options face time decay because they are “wasting assets,” naturally losing value with time.
- Options time decay is slower when expiration is far away but speeds up significantly in the last 30 days.
- Investors focus on finding options with real profitability potential by expiration, balancing intrinsic and extrinsic values.
