What happens to the time value of an option as it approaches expiration?

As an option approaches its expiration date, the time value of the option decreases. This phenomenon is known as time decay. Time value represents the potential for an option to increase in value before it expires, and as the expiration date draws nearer, there is less time for price movements to occur that could make the option more profitable.

When an option has a longer time until expiration, traders have more opportunity for the underlying asset’s price to move favorably, contributing to a higher time value. Consequently, as expiration nears, the probability of significant price movements diminishes, leading to a reduction in time value. By the time the option reaches expiration, its entire value may consist solely of intrinsic value (if any), with time value effectively having evaporated. This concept is crucial for traders and investors to understand, as it influences options pricing and trading strategies.