Time decay refers to the process that takes place when the value of an option or options undergoes a period of dropping. This change in option price is usually attributable to an identifiable set of circumstances, and takes place just prior to the end of the life of the option. Investors tend to be on the lookout for signs that time decay is about to take place. Accurately gauging the incidence and rate of time decay makes it possible to take steps to respond accordingly.
It is not unusual for an option to perform very well for most of its life, but begin to shift slightly in value one or two months before reaching the date of expiry. Many investors understand this, and do not see it as a cause for alarm. Often, the option will undergo a short drop period then rally toward the end of the period. However, when the drop continues, the option is in a state of time decay, and the investor has to determine whether or not to sell the option.
Knowing the right time to sell when time decay becomes evident can be tricky. All too often, investors choose to hold on a little longer than necessary, anticipating that the decline will level off. One of the best ways to properly identify time decay and sell the option before the price erosion cuts into the return on the investment is to look at the reasons for the drop in option price. If the underlying causes for the drop are due to circumstances that are likely to remain in place for an extended period of time, the investor will do well to sell as soon as possible.
It is important to note that the main risk with time decay has to do with long options. Attention to performance the last thirty to forty-five days is essential to avoid incurring a loss with the option. At the same time, a short option that is impacted by time decay may be a very good thing for the investor. The decline in value of related long options might actually help to increase the option price on short options, and make the investment more profitable than it would have been otherwise.