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Definition: Time Decay
This is also known as Theta or time value decay. Time Decay is a type of greeks that is mainly used to calculate the sensitivity of option price with respect to the time to expiration. Theta is calculated as following:
Theta = Change in Option Price/ Decrease in time to expiration
As the time to expiration decreases, the option price keeps reducing. This is because options are the flexibility to sell or buy an underlying at a price called strike price and when the expiration date is nearby, the underlying asset’s price becomes less uncertain and hence the option’s value reduces, be it a call option or put option. Hence options are also popularly known as wasting assets. The option value is derived from two components namely: intrinsic value and time value of an option. Intrinsic value of an option simply refers to the difference between the spot price and the strike price of an option. Time value of an option is referred to as the premium that an option buyer pays which is a function of time left for expiration of the option. Now as the expiration date approaches, the option’s time value reduces considerably and hence the option price reduces to its intrinsic value. This is because the probability of the option being in the money (For a call option, it is called to be in the money, when the strike price is below spot price) reduces as the option reaches close to its expiry date.
While some options, lose the value considerably, deep in the money options can be at least traded for the intrinsic value of the option. Simply speaking, the greater the uncertainty about an option’s expiry value, the greater is the option’s time value and as a result the option’s value as a whole. Or, in an uncertain world, Options or flexibility is what people crave for.