Premium decay, also identified as Theta decay, denotes the gradual reduction in the extrinsic value of an options contract as it approaches its expiration date. This temporal erosion of value is a fundamental aspect of options pricing dynamics.
Mechanism
The time value of an option diminishes because the window for the underlying asset’s price to move favorably decreases, thereby reducing the probability of the option finishing in-the-money. This decay accelerates significantly as the option nears expiration, particularly affecting out-of-the-money and at-the-money contracts.
Methodology
Options traders often exploit premium decay through strategies involving the selling of options or the construction of various spread trades, aiming to profit from the passage of time. Systems architecture in crypto options platforms typically incorporates real-time Theta calculations to assist traders in managing positions and assessing the time-value erosion of their holdings.
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