Beginning Option Strategies/Education

The Significance of Time Decay
Andrea Kramer (akramer@sir-inc.com)

Stock prices increase. Or they decrease. Or they stay the same. But options prices decrease over time, a phenomenon known as time decay.

Option buyers don’t have the same luxury of time as stockholders, since options are time-sensitive and have expiration dates. If the shares of an underlying security take a turn for the worse, the stockholder can hold on to his shares in hopes of a turnaround, no matter how long it may take. On the other hand, an option holder on the same underlying security is at a disadvantage, as the stock would need to recover within a limited amount of time (by expiration) in order for the position to profit.

As the expiration date approaches, the consequence on the value of an option is called time decay. Simply put, the longer the amount of time for market conditions to work to your benefit, the less time decay will be a factor on your option’s value.

The rate of time decay is also affected by how close to the money the option is. In other words, though two options may expire at the same time, time value will theoretically weigh on the options differently depending on their strike prices in relation to the current stock price.

The effect of time decay is most noticeable with at-the-money options, or options with a strike price at or near the current stock price. For example, if stock ABC is trading at $50, a 50-strike option would be considered at the money.

In this case, the ABC June 50 put – set to expire at the end of the week – may command a premium of $1.00, while the July 50 put – which has longer until expiration – may be trading for $2.35. Though both puts have the same strike, the further-dated option is more expensive to purchase, since the shares of ABC have more time to move in the money than with a front-month position.

However, time decay will weigh on the premium of in-the-money options less than at-the-money positions, since they’re most likely to end up on the plus side by expiration. For example, though the ABC June 45 call may be set to expire in just a few days, it still commands a premium of $6.60, considering it still holds intrinsic value. Meanwhile, the ABC June 40 call – which is deeper in the money – or the July 45 call – which has more time until expiration – would cost even more.

Moving on, out-of-the-money options will face the worst ramifications of time decay, since they would require a quick and significant move in the underlying stock price in order for the position to profit. And, the deeper the option falls out of the money, the less it will be worth. For example, an ABC June 45 put may cost a mere $0.15, but a deeper out-of-the-money June 40 put would cost even less, since the shares of ABC would need to rally even further in order for the put to avoid expiring worthless.

Nevertheless, a put with the same strike but more time until expiration would cost more. For instance, though the ABC June 40 and July 40 puts are both deep out of the money, the July-dated option would command a higher premium, since the shares of ABC have more time to make such an aggressive move.

Moving on, the rate of which an option’s premium erodes as expiration nears is measured by theta. A deep in- or out-of-the-money, front-month option will often harbor a theta of zero, meaning time decay should have little to no impact on the option’s value before expiration. However, a front-month option that is at or near the money will have a higher theta, meaning the price of the option will be more affected each day closer to expiration.

For instance, the at-the-money ABC June 50 call may have a theta of -0.41, implying that the option’s premium will erode by 41 cents each day closer to expiration (assuming the shares of ABC remain steady at the $50 level). Meanwhile, the at-the-money July 50 call may have a smaller theta of -0.16, indicating that the option’s value should decrease by 16 cents each day closer to expiration (again, assuming the shares of ABC remain steady at the $50 level).

In conclusion, while there are many other factors that contribute to an option’s worth (or lack thereof) – including implied volatility and historical volatility – time decay is something that every investor should be familiar with. By understanding the effect of time on an option’s worth, speculators can better choose which positions to enter, and which to avoid.


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