Time decay is a common term that we hear in the world of online investments. But have you ever wondered what is it? In simple terms, time is a measure of the rate of decline in the original value of the option contract with time. It changes at a faster rate when the expiry of option timing draws closer as there is no time for realizing any profit from the trade. It is often referred to as theta or options Greeks where there are others also like Vega, Rho, Gamma, and Delta and each of these formulae is efficient in assessing the risks associated with an options trade.
Why should pay attention to Time Decay?
Time decay is the depletion in the option value as the time of expiration date reaches near. The time value of an option reflects the role of time in its premium. As the expiration date approaches, the time value decreases, limiting the investor’s profit potential.
When calculated, this figure is supposed to come to negative always as time is unidirectional. The countdown starts from the option’s purchase and continues until expiration. So, this means, if much time is left for expiry, the time decay will become slower and vice versa.
What is the Correlation between Time Decay and Money?
Moneyness refers to the profitability level of an option which is measured based on its intrinsic value. Time decay and the time value of options are crucial for investors as they determine the profitability of choices. Time value loss occurs even if the underlying asset remains unchanged. This is because as more time passes, the option is less likely to become the money.
Investors tend to choose options that offer the highest profit potential by expiry. The amount of time left shows the price the investors should pay for any option. The impact of time decay, therefore, shows the investor whether the premium for any option is worth pursuing.
