What Is Time Decay in Stock Trading?

Time decay does not affect the price of stocks directly. However, time decay is a factor in some stock derivative products popular with traders.

Identification

Time decay is a factor in the trading of stock options. Option contracts are valid only until a certain expiration date.

Features

Stock options give option holders the right to buy shares of the underlying stock at a set price for a fixed period of time. A portion of the price paid for an option contract is time premium, or what the option seller receives for granting the rights included in the option.

Function

The portion of an option price that is time premium decreases as the expiration date for the contract approaches. An option that is out of the money will have the premium and option value time decay to zero at the expiration date.

Warning

Traders buy options with the belief the underlying security will make a big price move before the option expires. Time decay can negate the positive benefits of the underlying stock price moving in the correct direction.

Expert Insight

Professional stock option traders use different Greek alphabet letters to describe the mathematical properties of option prices. Theta is the amount an option will decrease in value each day or the time decay.

References

• Theta
• Time decay