An options contract gives the holder the right to buy/sell the underlying asset at a predetermined price. There is no obligation for the investor to exercise the options contract on the expiration date. However, the value or premium for a contract will change as the expiration date approaches. For the same rationale, options traders consider theta or time decay before making decisions. Read on to understand the importance of time decay for options traders.
Topics Covered:
What is Time Decay?
Options have a predetermined expiration date. When the expiration date for a contract is near, the asset has less time for price movements. For the same rationale, the price or premium of an options contract depends on the time left for expiration. The rate of decline in the premium or the value of an option is represented through time decay or theta. Time decay in options is essential for investors to analyse risks and make informed decisions. However, it is not the only factor that impacts the premium for options, as there are many other factors.
How Does Time Decay Work?
Now that you understand the importance of time decay, let us discuss how it works. Time decay or theta impacts the value of an option, also called the premium. As the expiration date for a contract approaches, its premium will decrease. The rate of decline in an option’s premium is represented through theta. When the expiration date arrives near, there is less time in the market for price movements. Also, the investor has less time to benefit from potential price movements. Let us understand how time decay in options works:
Components of the Premium
Before discussing decay options, it is essential to understand the components of the premium. The option premium has two components, which are intrinsic and time value. The intrinsic value is the ITM (In-the-Money) amount. One can calculate the ITM amount by calculating the difference between the strike price and the current market price of the underlying asset. On the other hand, time value is the part of the premium linked to the chances of price change before contract expiration.
Potential for Price Change
The premium for an options contract will change as time passes. When the contract is far from the expiration date, there are more chances for favourable price movements. However, the same is not the case when the expiration date is near. The chances of making a profit are less when the expiration date is near. For the same rationale, option sellers demand fewer premiums when the expiration date is near.
Time decay represents the rate at which the time value of an option declines. When the expiration date is near, theta accelerates. The time value of an option will decrease rapidly as the expiration date approaches. The speed is considerably high when only a few days are left in the expiration of the contract.
Impact of Expiry
Decay options work based on the intrinsic value of the contract. One will not exercise the contract when prices are not in favour. For instance, an investor purchases an options contract to sell stocks of a particular company at a given strike price. However, the price of the stock increases in the market before the expiration date. Since the spot price is more than the strike price on the expiration date, the investor will not exercise the contract.
Additionally Read: Demat Account Meaning
When the intrinsic value of the contract becomes zero due to unfavourable price movements, the time value also plummets. When the contract is not exercised due to unfavourable price movements, both intrinsic and time values become zero. Investors consider both these values to make informed decisions while trading in options.
Benefits of Time Decay
There are numerous benefits of time decay for options traders, such as:
-
Options sellers keep an eye on the time decay. As the expiration date approaches, the chances of keeping the premium increases. Similarly, options buyers consider the theta to make better investments.
-
The underlying asset might not move in the same direction as expected for options traders. For instance, an options seller might have expected the price to plummet, but it didn’t happen. However, the investor can still benefit through time decay, as it eroded the value of the contract.
-
It is used by options traders for investment research. It can be used together with other options Greeks to make informed decisions.
-
It works as a risk management tool for options traders. Investors use theta to calculate the premium risk associated with options.
Other Considerations
The time decay in options can depend on some other factors. For instance, the tick value can impact the premium for options. Tick value is the smallest amount by which the value of the contract can change. Similarly, the time value might not be influential for some option contracts. It happens when the intrinsic value dominates the premium of the contract.
The time value of a contract will depend on numerous factors, from volatility to interest rates. Anything that can boost the chances of price movements of the underlying asset will impact the time value.
One must also know that time decay in futures is not as popular as options. This is because the expiration date in futures does not work the same as options. You are obligated to exercise futures on the expiration date. For the same rationale, futures do not have a time value similar to options.
Conclusion
Options traders must understand the importance of time decay. Theta helps understand the decline in the option’s premium as the expiration date approaches. Investors must also be familiar with other options Greeks, as they help with investment research and options pricing. Learn more about theta or time decay in options trading now! Ready to dive into options trading? Open demat account today to start implementing your strategies and take advantage of market opportunities.
Learn More About Derivatives Trading