What is "theta decay" in the context of options?

In the context of options trading, "theta decay" refers specifically to the reduction in an option's extrinsic value as the expiration date approaches. Options are made up of intrinsic value, which is the actual value of the option if it were exercised at that moment, and extrinsic value, which is associated with the time value and volatility of the option. As the expiration date comes nearer, the time value of options diminishes, leading to a decrease in their extrinsic value. This decay occurs because there is less time for the underlying asset to move favorably, thereby reducing the likelihood of the option being profitable by expiration.

This concept is crucial for options traders, as they need to understand how the time remaining until expiration affects the pricing of the options they are trading. Understanding theta decay allows traders to make more informed decisions about when to buy or sell options, as the value of longer-dated options will decay more slowly compared to those with a short time frame until expiration.