What is time decay on options?

[Jane Goodwin]

[Justin Freeman]

One of the key features of options is that they have an ‘expiry date’. At that time, at the discretion of the holder of the options they can be exercised and converted into the underlying asset that they relate to. The conversion will be at a previously fixed price (the exercise price) so in the run-up to expiry date the value of the option will be a function of where the price of the underlying instrument is in relation to the exercise price. Take for example, a Call option in ABC Inc that converts into a holding of ABC equities and has an exercise price of 50 cents. If on expiry day ABC Inc equities are trading at 55 cents then exercising the option will result in a 5 cent revenue gain per share issued. Net profit would be calculated by also considering the premium paid to buy the option in the first place and administrative costs. Should these prices occur on expiry date the option would be described as having Intrinsic Value of 5 cents. If the underlying was trading at any price below strike price then the Intrinsic Value would be zero. Time decay helps explain the process of calculating the role time plays in determining the price of options during the run up to expiry date. The strike price of the option and current price of the underlying are known but price changes between that time point and expiry date are not. A particularly interesting point about the decay is that it is non-linear. An option that has 200 days until expiry will over a course of 24 hours experience minimal time decay. There are after all 199 more days for significant price moves in the underlier. Extrinsic Value is influenced by time decay to a much greater rate as expiry draws near. Another interesting factor is that the price of an in the money option can actually decrease even though the price of the underlier moves in a favorable direction. For example, a call option near to expiry might see time decay erode 8 cents of its value even though the underlier has increased in price by 3 cents. The rate at which time decay changes over a certain unit of time is referred to as Theta.