Time decay refers to the decrease in an option’s value over time.
The price of every option is determined by two components: time value (also known as extrinsic value) and intrinsic value.
The decay in time value accelerates as the option approaches expiration.
Traders can use this knowledge to design trades that maximize profit potential.
How Options Time Decay Works
Every option you trade has an expiration date tied to it. This can be days, weeks, months, or even years away, but time value erodes every second of the day, even on weekends, when the market is closed.
The decay starts slowly at first and gains speed as it approaches expiration.
The chart below illustrates the erosion of value over time.
Starting far away from expiration (left), the time value of an option declines at an accelerating rate.
By the time expiration arrives (right), there isn’t much time value left in the option.
The time decay of an option only erodes the extrinsic value, leaving the intrinsic value untouched.