DEFINITION:
Time decay, known as theta, refers to how an option loses value as its expiration date gets closer.
Time decay means the value of an options contract reduces as its expiration date gets closer.
Imagine XYZ stock is at ₹40, and you want to buy a call option for ₹50 strike price with 180 days until it expires. Let's say you pay ₹200 for this contract. If, at any point within the next 180 days, XYZ's price goes above ₹50, you can use the option to buy shares at a lower price.
Options have a specific expiration date, which is the final day for exercising an in-the-money options contract in the United States. Typically, this date falls on the Saturday following the third Friday of each month.
Suppose there are only 30 days left until the option expires; that same option might cost just ₹50 because there's less time for XYZ's price to change enough to make using the option worthwhile.
As each day goes by, time decay makes an option's value go down. This drop in value speeds up as the expiration date gets closer. The price of the option falls more each day in the week leading up to expiration compared to a month before.
Generally, options that are "in the money" lose less value due to time decay since they have inherent worth. However, options "at the money" or "out of the money" tend to lose more value because of time decay.
Alternate name:Theta (in trading)
Time decay happens due to how options prices are set. Generally, options that are more likely to be used have higher prices. This means options that are in or near the money cost more compared to those far out of the money. Also, options with distant expiration dates cost more than those expiring sooner.
An option is considered "in the money" if using it would make you money. For instance, if you have a call option with a ₹50 strike price on a stock trading at ₹55, that option is "in the money." You could use it to buy shares and sell them right away, making a ₹5 profit.
Let's explore why this happens. If an option for a stock at ₹25 is ₹10 "out of the money" and expires the next day, it's unlikely the stock's price will change by ₹10 in just one day. However, if the option is ₹10 "out of the money" but the expiration is a year away, there's more time for the stock's price to change significantly.
Options "in the money" have actual worth because you can use them for instant profit. "Out-of-the-money" options hold value because there's a chance that future changes in stock prices could make them valuable. As the chances of an option becoming valuable decrease, people are less willing to pay much for it.
For folks trading options, remember that the expiration date affects how much an option is worth. If you buy options very close to their expiration, their value can decrease rapidly.
Some traders make use of this by selling options nearing expiration. But, be aware, selling certain options involves risks, including the chance of facing unlimited losses.
