What happens when an option approaches expiration?

When an option approaches expiration, it experiences a phenomenon known as theta decay, which refers to the reduction in the option's extrinsic value as time passes. Extrinsic value, often referred to as time value, is the portion of the option’s overall value that is attributed to the time remaining until expiration. As the expiration date nears, there is less time for the underlying asset to move significantly, leading to a decrease in this extrinsic value.

This process occurs because options lose value over time due to the uncertainty of the underlying asset's performance. If an option is out-of-the-money as it approaches expiration, it may lose nearly all its extrinsic value, reflecting the reduced likelihood of it becoming profitable.

Understanding this concept is critical for options traders as they develop strategies around expiration timelines.