Theta Decay (also known as Time Decay) is one of the most important concepts to grasp when dealing with options. Think of it as a melting ice cube. When you buy an option, part of its price—the premium—is for the time you have until it expires. This time value is like an ice cube. Every single day that passes, a little bit of that ice melts away, reducing the option's value, even if the underlying stock price doesn't move an inch. This daily erosion of value is Theta Decay. It represents the risk that time poses to the option buyer. The “Theta” itself is one of the Greeks, a set of risk measures used in options pricing. Specifically, Theta quantifies how much value an option is expected to lose per day. For option sellers, this daily decay is not a risk but a source of potential profit, as they collect the premium upfront and benefit from its value decreasing over time.
An option's premium is made up of two parts: intrinsic value and extrinsic value. Intrinsic value is the “real” value, the amount an option is profitable by if exercised immediately. Extrinsic value is everything else, primarily composed of time value and implied volatility. Theta Decay only eats away at the extrinsic value. The intrinsic value is safe from time's ravages. The rate of this decay is not constant. Much like an ice cube melts faster as it gets smaller and the day gets warmer, Theta Decay accelerates as the option's expiration date approaches. The decay is relatively slow when an option has many months left, but it picks up speed dramatically in the final 30-60 days. The rate of decay also depends on whether the option is in-the-money (ITM), out-of-the-money (OTM), or at-the-money (ATM).
How you feel about Theta Decay depends entirely on which side of the trade you're on.
If you buy an option, time is your enemy. You are in a race against the clock. The underlying stock doesn't just need to move in your favor; it needs to move enough and fast enough to outrun the daily melting of your premium. Every day you hold the option, a small piece of your investment vanishes into thin air. This is why buying short-dated OTM options is often compared to buying lottery tickets—the odds are stacked against you, with Theta Decay working tirelessly to push your option's value to zero.
If you sell (or “write”) an option, time is your best friend. You collect the premium upfront, and your goal is for the option to lose value. Theta Decay works for you 24/7, even on weekends and holidays. Each day that passes, the option you sold becomes a little less valuable, increasing your potential profit. If the option expires worthless, you get to keep the entire premium you collected. This predictable decay is the primary reason many professional traders prefer to be sellers of options rather than buyers.
At first glance, options trading seems like the polar opposite of value investing. Value investors focus on the long-term fundamental value of a business, while buying options is often a short-term, speculative bet on price direction and timing. However, a savvy value investor can use Theta Decay to their advantage by acting as an option seller. This approach turns a speculative instrument into a conservative tool for income generation and strategic stock acquisition. Here are two classic strategies:
In both scenarios, the value investor isn't speculating. They are using the systematic and predictable nature of Theta Decay to either generate income from assets they already own or to acquire desired assets at a better price. It's a disciplined way to make time—and Theta—work for you.