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how the gears turn
Pricing Options: Time
How the passage of time affects option prices
Milk Money
Imagine you run a food stand that sells cartons of milk. Some of your cartons expire in one week, while the rest expire in two or more. Unless you want to end up with unsold expired milk, you need to adjust the pricing so the expiring milk is cheaper than the later-dated cartons. This will incentivize customers to take the expiring inventory off your hands before it goes bad. The price difference between the one-week and two-week cartons is time value. The closer the milk is to expiration, the less time value you can charge. The same goes for options.
Longer-dated options have more time to be useful to the buyer, which makes them valuable. As time passes, however, their window for usefulness shrinks, making them less attractive to buy. Their extrinsic value will decay as a consequence, resulting in cheaper prices.
Time Value In Terms of Risk
At their core, option prices are determined by their perceived risk.
The longer an option has before it the greater potential risk it carries. This is because the share price has more time to change by greater amounts.
You may recall that greater risk results in greater . As time passes, risk is diminished and extrinsic value decays alongside it. For holders, decaying value can become a drag on profitability. For decay is favorable because their goal is to the position at a cheaper price. Learning these time decay dynamics will be an important part of becoming an effective strategist.
The longer an option has before it the greater potential risk it carries. This is because the share price has more time to change by greater amounts.
You may recall that greater risk results in greater . As time passes, risk is diminished and extrinsic value decays alongside it. For holders, decaying value can become a drag on profitability. For decay is favorable because their goal is to the position at a cheaper price. Learning these time decay dynamics will be an important part of becoming an effective strategist.