Why Options Lose Value: Time and Implied Volatility

Every option price has two parts. Intrinsic value is what the option would be worth if it ended right now. Extrinsic value is everything else: what buyers pay for time and the chance of a bigger move. With a stock at $105, a $100 call priced at $7.00 has $5.00 of intrinsic value and $2.00 of time value. A $110 call on the same stock has no intrinsic value, so its whole price is time value. Where a strike sits relative to the stock price is called moneyness.

Time decay: the melting ice cube

Time value shrinks to zero by expiration. Theta estimates how much an option loses each day from time passing alone, if nothing else changes. It’s quoted per share, so a theta of −0.05 means about $5 per contract per day. Traders call it a melting ice cube: the value drains slowly at first, then faster near the end. Decay is gentle when many days to expiration remain and speeds up in the final week or two, especially for at-the-money options. Out-of-the-money options have fewer dollars to lose, but if price doesn’t move toward the strike, they can lose most of their value well before expiration day.

Implied volatility: the move that’s priced in

The other big input is implied volatility. It’s the size of move that option prices imply, quoted as a yearly percentage. When traders expect bigger swings, they pay more for options and IV rises. A rough rule: divide IV by 16 to get a one-day move of about one standard deviation. In a simple model, about two days in three stay inside that range. A stock with 32% IV is pricing about a 2% daily move, roughly $2 either way on a $100 stock. IV says nothing about direction, and the market’s estimate can be wrong. It also changes over time: IV tends to rise when markets get nervous or before scheduled news, and to drift lower when things calm down. Vega measures how much an option’s price changes for a 1-point change in IV. In the example above, the 30-day call is worth about $2.29 at 20% IV, $3.43 at 30% and $4.57 at 40%, with the stock unchanged. That’s a vega of about $0.11 per IV point, or about $11 per contract.

Put together, a long option needs the move to be big enough, soon enough, and larger than what IV already priced in. That’s why being right about direction isn’t enough. Before buying, many traders compare an option’s break-even with the move that’s priced in: if the break-even sits well beyond it, the trade needs an unusually large move to pay off. Sellers face the mirror image: they collect time value but carry the risk of a move bigger than expected. For members, StratosHedge’s Calendar shows an expected move for upcoming earnings reports where it’s available, which tells you how large a move options were pricing.