Time Decay

Time decay is the tendency of an option's price to shrink, all else being equal, simply because less time remains until it expires. An option is a contract that gives the buyer the right to buy or sell a stock at a set price by a certain date, and part of what a buyer pays for is time itself — time for the stock to move in a useful direction. Every day that passes without the stock making that move, some of that "time value" evaporates from the option's price.

This happens because an option's premium is made up of two pieces: intrinsic value (what it would be worth if exercised right now) and extrinsic, or time, value (everything else, mostly the possibility of favorable movement before expiration). As expiration approaches, there are fewer chances left for the stock to move, so the market pays less for that possibility. The rate of this erosion is measured by a number called theta, which estimates how many cents or dollars an option loses in value per day, holding the stock price and volatility constant.

The nuance that trips people up is that time decay is not linear. It accelerates as expiration gets closer, so an option with sixty days left decays slowly, while the same option with five days left can lose noticeable value in a single day. Decay is also not something you can isolate in real life — the stock price and implied volatility are moving at the same time, so a trader can be "right" about direction and still watch the option lose value if time decay outweighs the gain from the stock's move, or a stock can sit still and the option can still lose money purely from time passing.

Time decay works against option buyers and in favor of option sellers. A buyer is racing the clock; a seller is essentially being paid to let that clock run out, collecting the eroding time value as profit if the stock does not move against them enough.