All options have two stores of value — intrinsic and time. While the intrinsic value of an option remains fairly constant throughout its life, it loses its time value the closer it gets to expiration. This is known as time decay, and is measured by theta (see “Wasting away,” below).
Theta is not a constant, but accelerates on a concave or convex basis as the option approaches expiration. An at-the-money option’s value will accelerate to zero as it approaches expiration.
Grigoletto explains that theta tries to account for the unknowns of the future. “Anything can happen over the period of expiration. If you have a 30-day option, as you get closer to the last couple of days, there is less chance that you are going to get a dramatic move,” he says. “Still, there’s the opportunity that something dramatic can occur in those last few hours before expiration.”
Theta is particularly important for options with stocks or futures that are not moving much. “If you own an option, it tells you how much you will lose every day or week by owning the option if the underlying price is unchanged,” Bittman says. “If you are short the option, then theta tells you how much you’ll make if it remains unchanged.”
This is important because options that expire out of the-the-money are worthless. So, if a company’s shares are at $100, and you bought a two-month call at a $105 strike price for $1, you are not going to make any money unless the stock goes higher than $106 within the next 60 days. If the stock is at $105.30 with 10 days to expiration and the option is worth 50¢, you would still be losing money even though the stock moved in your direction. On the flip side, the option seller is sitting back and watching time decay working for him.