Definition
The term time decay refers to the theoretical decline in the value of an option over time. Time decay directly affects the extrinsic value of an option.
Explanation
Also known as theta decay, time decay is the theoretical decrease in value of an option over time. Time decay for an option is quantifiable and can be expressed in terms of a theta value. When selling an option, the theta value will be positive, while the theta value will be negative for the buyers of an option. This is because the total value of an option, or the premium paid, can be expressed as:
= intrinsic value + extrinsic value
Where the intrinsic value is equal to the moneyness of the option. For example, an in-the-money option has intrinsic value while an out-of-the-money option has no intrinsic value. The extrinsic value of an option is the premium an investor pays for the possibility of being able to profit from the price movement of the underlying security.
At any point in time, the extrinsic value of an option is a function of time to expiration and the volatility of the underlying asset. As the expiration date grows closer, there is more certainty with respect to the underlying security's price at expiration, therefore the effect of theta decreases.
Investors that buy options (long positions) are negatively impacted by theta decay, since there is less uncertainty around the underlying security's price at expiration and less intrinsic value in the option's premium. Investors that sell options (short positions) are positively impacted by theta decay since the value of the option goes down over time and it's possible to purchase them back at a lower price, close out their position, and realize a gain.
Finally, it should be noted that time decay isn't linear. Everything else being equal, an option with 150 days to expiration will have a slower decay value than an option with 30 days until expiration.
Related Terms
delta, delivery, debit spread, credit spread
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