Value of an option contract decreases as it nears the expiration date. This decrease in value is described as Time decay, which is technically also called Theta. As an investor or trader you should keep in mind that the expiration date of a contract impacts option prices.
Out of the money (OTM) call and put options are more affected by Theta factor than In-the-money (ITM) option contracts.
When the expiry date is far away, time decay will have a small impact on the option prices. As it nears the expiry, time decay accelerates.
If you are planning to buy options which are very close to expiry, then you must be prepared for a drop in price as they drop very quickly if the underlying asset prices do not move or it moves sideways.
For example, suppose Mr Kumar is planning to buy a call option contract of XYZ limited stock which is trading at Rs 100 with a strike price of Rs 250. The expiry date of the contract is 60 days away.
As the expiry is far away the premium must be higher in comparison to a contract which is about to expire in this month with the same strike price of Rs 250. The reason for paying lessor premium for the current month expiry contract with the same strike price of Rs 250 is due to time decay.
Suppose Mr Kumar has paid Rs 25 as premium for the contract which is about to expire after 60 days. The current month expiry contract price will be less than Rs 25 due to time decay factor.
Theta will decrease the value of the option each day that passes towards expiry.
In the money call and put option contracts have less time decay as they have intrinsic value. At-the-money call and put option contracts have more time decay in comparison to In-the-money contracts.
Out of the money call and put option contracts have significant time decay as they don’t have any intrinsic value.
Due to time decay or Theta factors, options that are In-the-money are more expensive than the ones that are far out of the money. Similar to this, options with far month expiry will be more expensive than the current month expiry.
Due to the time decay factor, many experienced traders prefer to sell options close to expiry if they expect the market or underlying asset prices to move sideways.
