Time decay refers to the decrease in an option's price as time passes and as the option gets closer to its respective expiration date. An option starts decaying its value as soon as the option is initially bought and continues until expiration. This characteristic of options has its pros and cons for traders. Read on to know more about options time decay. In this blog, we have explained everything about time decay in options.
Time decay in options
The reduction in the value of an option as the time to the expiration date comes closer is called time decay in option. Option prices start to decrease as time passes. An option starts decaying its value as soon as the option is initially bought and continues decaying in value until expiration.This rate of time-value decay is represented by one of the options Greeks “Theta (θ)”. In this blog, we have explained time decay to you and completely demystified it so that you can understand exactly what time decay is and you can understand it on a basic and deep level. Before explaining time decay, we first need to discuss the two components of every option's price.
The first component is called intrinsic value which can be interpreted as the value of that option's ability to purchase or sell shares of stock at the options strike price as opposed to the current market price of the shares.
Intrinsic Value of Call Option
A call option will have intrinsic value when the stock price is above the call options strike price.
The formula for calculating a call options intrinsic value is the difference between the current market price of the shares and the call options strike price.
Intrinsic value of Call Option = Current Price - Strike Price
But this formula only works if the stock price is above the call option strike price because the intrinsic value will either be 0 or it will be a positive number.
Intrinsic value will never be a negative number. Therefore, if a strike price of a call option is above the current stock price no call option trader would ever choose to purchase shares of stock at a higher price by exercising the option when they could simply buy shares of stock at the current market price and they don't need to use the option.
So, for that reason, the intrinsic value is either going to be 0 or it will be a positive number.
Intrinsic Value of Put Option
In the case of put options, a put buyer can sell or short shares of stock at the put options strike price and for that reason, a put option will have intrinsic value when the stock price is below the put option strike price.
The formula for calculating a put options intrinsic value is the put options strike price minus the stock price.
Intrinsic Value of Put Option = Strike Price - Stock Price
If you do that calculation when the stock price is below the put options strike price you will get a positive number which will be the difference between the strike price and the stock price.
In the case where the stock price is above a put option strike price if you use that formula, you will get a negative number, and as we have seen earlier that option’s intrinsic value will never be negative so that number will either be zero or it will be a positive number.
So, in the case of having a put option where the strike price is actually below the stock price, that put option will have zero intrinsic value.
Intrinsic value is the first and the most stable component of an options price because intrinsic value does not change as time passes.
The only way intrinsic value will change is if the stock price changes. Otherwise, if
the stock price remains the same then the option does have intrinsic value and it will
never change as long as the stock price remains the same.
The time or the passage of time has no impact on an option intrinsic value which brings us to the second and the more unstable portion of an options price i.e. extrinsic value or it is also known as the time value.
Extrinsic Value (Time Value of an Option)
The easiest way to interpret extrinsic value or time value in an options price is the portion of the options price that is associated with the potential for that option to become more intrinsically valuable before it expires. Options with more time until expiration will have more extrinsic value than options with less time until expiration.
Why do options have time decay?
Why do options with more time until expiration have more extrinsic value because over longer periods a stock price has greater expected price ranges and for that reason options with more time until expiration have more potential value changes through big changes in the stock price.
If all other things like volatility levels and underlying assets remain the same, the longer the time to expiration, the more value the option will have in the form of time value. Deep In-The-Money options and Deep Out-Of-The-Money options have less time value. Intrinsic value increases as the option go In The Money. An option has the highest time value or extrinsic value when it is At-The-Money (ATM) options but the ATM option has no intrinsic value.
For example, if we look at options with 365 days to expiration they will be trading with tons of extrinsic value because there are still 365 days for the stock price to change significantly and that means there are 365 days for that option to become way more valuable particularly intrinsically valuable through a big change in the stock price.
If you look at options with very little time until expiration they will not be trading with much extrinsic value, because with less time until expiration the options valuations are more certain. Because there's less time for the stock price to move and therefore there's less time for the option price to experience a big change.
As big changes in the stock price typically do not happen in short periods we can observe time decay or extrinsic value decay by simply looking at options of the same type and strike price across different expiration cycles.
Longer-term options will have more extrinsic value than shorter-term options of the same type and strike price. As time passes and as an option gets closer and closer to its expiration date that option's final value becomes more certain. That is how time decay in options trading can be understood.
How to calculate time decay in option?
Time decay in options is measured by one of the options greek “Theta (θ)” which is the rate of reduction in the value of an option with respect to time. The time value of an option is calculated as follows:
Time Value = Option Premium - Intrinsic Value
How options time decay can benefit traders
Many novice options traders tend to buy calls and puts because of their limited risk and unlimited profit potential. By doing so investors and traders try to speculate only a fraction of their capital. Time decay may seem to be a disadvantage of the option and because of time decay many investors termed options as “Expense Trades”. But options traders can benefit themselves from the time decay feature of options. They can turn this reduction in the value of an options contract into potential profits by collecting time-value premiums paid by option buyers. This way, instead of losing out, traders can make time value decay money in the bank even if the underlying asset is stationary.
Time decay is the characteristic of an option by which its value decreases as time passes and reaches expiry. For straight options buyers, this may be a disadvantage. But option sellers can benefit themselves from time decay by collecting time value premium from the option buyer.