Options Premium Decay, also referred to as theta decay, signifies the reduction in an option’s extrinsic value as the contract approaches its expiration date. This phenomenon is a systematic decrease in the time value component of an option’s price.
Mechanism
An option’s premium comprises intrinsic value and extrinsic value, the latter being primarily influenced by time to expiration and implied volatility. As each day passes, the remaining time for the underlying asset to move favorably diminishes, causing the time value to steadily erode. This decay accelerates as the option nears expiry, reflecting the decreasing probability of its profitable exercise.
Methodology
The strategic implication of options premium decay is crucial for traders. Those writing options aim to profit from this erosion of value, while options buyers must account for it as a cost that reduces the contract’s worth over time. Understanding this decay is fundamental for pricing, holding period decisions, and risk management in crypto institutional options trading.
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