Option premium in relation to the Current Market Price (CMP) is always higher, at the beginning of the new month (after previous month’s option expiry on the last Thursday). Again in relation to the CMP, option premium of Next Month Option (August here) is higher than the current or Near Month Option (July here). Still higher would be the Far Month Option Premium (September here). As we approach the expiry date, the premium in relation to CMP starts falling until a day or two before expiry, the premium would be almost zero. This difference is because the buyer of the option for farther off periods stands a greater chance of making profits if given more time to hold the option. The seller therefore deserves to get a higher premium. This intrinsic quality of any option to fall in value with time in relation to the CMP is called the TIME DECAY.
For example, let us imagine at Nifty value of 4500 (CMP), the 4500 Call option at the beginning of the current month (July) was trading at Rs 50/-. A day before expiry, if Nifty is still at 4500, the Call premium would be close to Rs 4/- or Rs 5/-. If Nifty closes at 4500, the value of the call premium would be zero. If Nifty closes at 4510, the call will close at Rs 10/-which is again zero premium in relation to CMP.
The significance of Time Decay
Most retail investors are buyers of options. What one should realize is that due to the inevitable time decay, a buyer has the dice loaded against him, right from the time he enters into the contract. He has to depend on the volatility of the scrip to book his profits along the down-hill journey of the option premium. He, of course, has the advantage that his loss is limited and he has to pay no deposit apart from the actual amount of transaction.
The option writer on the other hand, has the dice loaded in his favor from the time he sells the option (as a primary seller, without having bought the option first). The time decay works to his advantage on a daily basis. As long as the scrip remains stagnant, the premium continues to fall, adding to his gains. He pays the price by the mandatory deposit into the stock exchange and also by accepting the possibility of unlimited loss (but writers usually exit with a small profits and do not hold on to their positions too long to avoid undue risks).