**As mentioned in Part 3, the Time Value component of an option price will decline or “erode” as expiration is nearing (i.e.**

__The Behavior of Time Value__**Time Decay**).

The

**rate of decline of option’s time-value**resulting from the

**passage of time**(i.e. rate of

**Time Decay**) is known as

**THETA**, which is one of the Options Greeks.

Comparing Theta

**at a certain point of time**between ATM (At-The-Money), ITM (In-The-Money) & OTM (Out-of-The-Money) options, Theta is typically

**highest**for

**ATM options**, and gradually decreases as options move towards ITM and OTM.

This is understandable because ATM options have the highest time value component, so they have more time value to lose over time than an ITM or OTM option.

Comparing Theta

**over time**, there are different behaviors between ATM and ITM / OTM options:

**For ATM options**, as the Time Value component of an option price decreases when the option is approaching expiration, the rate of time value decrease is

**accelerating**(i.e.

**Theta is increasing**) as it is getting closer to expiration.

This means that the amount of time value disappearing from the option price per day gets

**bigger**with each passing day. For ATM option, time value decreases sharply particularly in the last 30 days before expiration.

On the other hand,

**for both ITM & OTM options**, Time Value actually decreases at a

**decelerating**rate as expiration nears. In other words,

**Theta decreases**as the option is approaching expiration.

This means that the amount of time value disappearing from the option price per day gets

**smaller**with each passing day.

This Time Value behavior can be seen in the following graphs:

1) Time Value of

**ATM Option**:

2) Time Value of

**OTM Option**:

Note: Both pictures courtesy of Sigma Options

Therefore, based on the above, we can summarize as follow:

**For ATM options**, Theta (i.e. the rate of time value decline as the time passes) is typically the

**highest**(as compared to ITM & OTM options), and will be

**increasing**(i.e. the rate of time value decrease is

**accelerating**) as the option is nearing expiration.

**For both ITM & OTM options**, Theta is relatively

**lower**(than ATM options), and will be

**decreasing**(i.e. the rate of time value decrease is

**decelerating**) as the option is nearing expiration.

__The Impact of Implied Volatility (IV) on THETA__When Implied Volatility (IV) decreases, Theta will be lower, especially when it is approaching expiration.

On the other hand, when IV increases, Theta would be higher.

Why is it so?

As discussed earlier in this post, time value as the price that people are willing to pay for the chance / uncertainty as to whether or not an option will finish ITM.

The more uncertain, the higher the time value will be.

When IV decreases, such uncertainty will be lower, particularly when the option is nearing to expiration. This lower uncertainty will then be reflected in lower time value. Since Theta is the decrease of time value due to the passage of time, Theta will naturally be lower because it has less time value to lose over the remaining time to expiration.

__Related Topics:__* FREE Trading Educational Videos You Should NOT Miss

* Options Trading Basic – Part 1

* Options Trading Basic – Part 2

* Understanding Implied Volatility (IV)

* Option Greeks

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