Rahul Gupta (Project Controller ACA MBA(Fin.)) 15 May 2010
What Does Time Decay Mean?
The ratio of the change in an option's price to the decrease in time to expiration. Since options are wasting assets, their value declines over time. As an option approaches its expiry date without being in the money, its time value declines because the probability of that option being profitable (in the money) is reduced.
Time decay of an option begins to accelerate in the last 60 to 30 days before expiry, provided the option is not in the money. But in the case of options that are deep in the money, time value decays more rapidly. The market finds these options too expensive compared to other strike prices or futures. As such, the holders of deep-in-the-money options nearing expiry discount the time value to attract buyers and in turn realize the intrinsic value.
The greater the certainty about an option's expiry value, the lower the time value. Conversely, the greater the uncertainty about an option's expiry value, the greater the time value.