Time decay, also known as theta decay, is a significant factor for options as they approach their expiration date. It affects the value of both call and put options, including Index call options like Nasdaq Options and Nifty Options (the two markets that we actively track in Amxsys).
For example, for an Index call option with a two-month expiry, time decay can be a notable factor. As time passes, the option’s value tends to decrease due to diminishing time value. This is because as the expiration date approaches, the likelihood of the option ending up in-the-money decreases.
The rate of time decay accelerates as the option approaches its expiration date, particularly in the last two weeks. This phenomenon is known as “accelerated time decay” or “time decay ramp-up”. So you have to be very careful in buy options with less than two weeks time for expiry. Maximum losses in options trading (while buying options) happen while trading options with less than 2 weeks of time for expiry. Conversely, the last 2 weeks is where Option sellers make regular profits, because the time decay is very strongly in their favor.
It’s important to note that time decay is not constant and varies based on factors such as volatility, interest rates, and underlying price movements. Higher levels of volatility and longer time to expiration can reduce the impact of time decay to some extent.
Traders and investors need to be aware of time decay when trading options and factor it into their strategies. Managing the effects of time decay is crucial, especially for options with longer expiries, to make informed decisions regarding entry, exit, and position sizing.