What is the meaning of the term ‘theta decay’ and why does it happen?

Theta decay, also known as time decay, refers to the gradual reduction in the value of an option with the passage of time. It’s a crucial concept in options trading and is represented by the Greek letter ‘theta’ (Θ). Theta measures the rate at which the value of an option decreases as time passes, all else being equal.

There are several reasons why theta decay occurs:

  • Reduced Time Value: As the expiration date nears, the time value of an option diminishes. Time is a crucial component of an option’s value, and as time passes, the option has less time to move in a profitable direction.
  • Diminishing Volatility Impact: Options are influenced by market volatility. However, as expiration approaches, the potential for significant price swings diminishes, reducing the impact of volatility on the option’s price.
  • Decline in Extrinsic Value: Theta decay primarily affects an option’s extrinsic value, which comprises the portion of the option price that’s not attributed to its intrinsic value. Extrinsic value reflects the potential for the option to gain value before expiration, and as time elapses, this value decreases.

Options traders need to be mindful of theta decay, as it can erode an option’s value over time, especially if the underlying asset price remains stagnant. Understanding theta and its impact helps traders make informed decisions regarding when to enter or exit options positions based on time considerations. Read more about theta decay on this blog.