Time Decay

Time decay, or theta, represents the theoretical amount (if all else remained equal) by which option premium will decrease per day.  The closer an option is to expiration, the higher the time decay rate or theta would be (if all else remains equal).  Theta measures the loss in time value – note that intrinsic value will vary based on the movement in price of the underlying.  The theoptionsguide.com notes that “longer term options have a theta of almost 0 as they do not lose value on a daily basis.

Theta values, as time to expiration approaches, do not follow a linear function and determining theta is not as simple as dividing time value by the amount of days till expiration.  It is a complex function, and it is a theoretical model, not pure science.

How Theta Behaves in Relation to Time to Expiration

As expiration approaches, it is likely Theta would become increasingly negative. At the end of the second to last trading day, with one day left until expiration, the Theta should equal the entire amount of time value left in the option.

On the other hand, as time to expiration increases, theta increases.

From: One of the sources I thought was very helpful was optionseducation.org.

 

Leave a Reply

Your email address will not be published. Required fields are marked *