Time Decay, also known as Theta, is a pivotal concept in options trading. It refers to the rate at which the value of an option decreases as time passes, approaching its expiration date. This concept essentially implies that the longer you hold an option, the more its extrinsic value diminishes, all other factors remaining constant.
Time decay is not linear – it accelerates as the option’s expiration date approaches. This means an option loses value at an increasing rate the closer it gets to expiry. For example, a three-month option is going to lose value much more slowly than a one-month option.
The rationale behind time decay is that as the expiration date nears, the probability of the option being in-the-money (profitable) decreases. Therefore, time decay can be considered as the option’s cost of possession. This is why option sellers (writers) benefit from time decay while buyers often see it as a disadvantage. Understanding the impact of time decay on the value of options is a key aspect of successful options trading.
