What it means
The price of an option has two parts. The first is intrinsic value, which is the amount the option would be worth if used right now, and the second is time value, which is the extra amount buyers pay for the chance that things improve before expiry.
Time decay is the gradual shrinking of that second part. The decay is not steady.
It tends to be slow when expiry is far away and speeds up in the last weeks, so an option can lose a large share of its time value just before it expires. At the moment of expiry, the time value is zero and only the intrinsic value is left.
The measure traders use is called theta, which shows how much an option's price is expected to drop for each day that passes, assuming everything else stays the same. Buyers of options suffer from time decay because it works against them, while sellers of options benefit from it, because the contract they sold loses value in their favour.
Time decay matters in business whenever options are used. Companies that hedge currency or commodity prices with options pay for time value as part of the premium, and companies that grant employee options record a cost that depends on the time to expiry.
Understanding it helps a treasurer choose between short and long dated contracts. Other things also change an option's price, especially movements in the underlying asset, and changes in expected volatility.
These effects can be larger than time decay in the short run, which is why decay is best understood as a constant pull on value and not a precise prediction of price. A common mistake is to buy a short-dated option for a hedge and to forget that the premium is being used up each day.
A longer-dated option costs more upfront but loses value more slowly.
In practice
Real-world examples
Example 1
A trader buys a short-dated call option for $2 per share, hoping for a jump in the share price. The jump does not come, and by expiry the option is worthless, because all of its value was time value that has decayed away.
Example 2
A manufacturing company buys currency options to protect a payment due in six months. The treasurer knows part of the premium paid is time value, so she compares the cost against a forward contract that has no premium.
Example 3
An investor sells options on shares she already owns, collecting the premium. She is happy to see time pass, because decay reduces the value of the options she sold and increases her gain.
Think of it
Time decay is like buying an ice cream cone on a hot day. The longer you hold onto it without eating it, the more it melts away until nothing is left, regardless of how much you originally paid for it.
Formula
Calculation
Option premium = Intrinsic value + Time value
Time value = Option premium - Intrinsic value
A call option gives the right to buy a share at a strike price of $100. The share trades at $102, so intrinsic value = 102 - 100 = $2. The option's premium is $5, so time value = 5 - 2 = $3. One month later, with the share still at $102, the premium has fallen to $4.20. The intrinsic value is still $2, so time value = 4.20 - 2 = $2.20, and the time decay over the month is 3.00 - 2.20 = $0.80 per share.Case study
Seen in the real world
Quillfeather Exports is an illustrative, fictional company that bought one-month currency options each month to hedge a regular payment. Over a year, the premiums totalled $96,000, and the finance director noticed that most options expired unused.
She analysed the cost and found that much of the premium was time value that decayed to zero. Switching to three-month options reduced the number of purchases, and the total premium over the year came to $72,000 because the per-month decay was slower.
She also considered a forward contract, which had no premium but removed the benefit of favourable moves. In this illustrative story, the board chose a mix of both, based on how much flexibility the business really needed. The treasurer agreed to report the premium spent and the protection gained each quarter, so the board could judge whether the cost remained worthwhile.
Watch out
Common mistakes
- Thinking an option keeps its value if the share price stays the same, when the time value will still fade away.
- Assuming decay is the same every day, when it usually speeds up as expiry approaches.
- Buying very short-dated options for protection without counting the premium that is lost each time.
Questions
People also ask
Who gains from time decay?
The seller of an option gains, since the contract loses value as time passes, while the buyer is hurt.
What is theta?
It is the measure of how much an option's price falls with each day that passes, assuming other factors are unchanged.
Does time decay apply to shares or bonds?
Not in the same way, because time decay is specific to options and similar contracts with a fixed expiry date.