Do Futures Have Time Decay and How Are They Priced?

Futures contracts are standardized legal agreements to buy or sell an asset at a predetermined price on a specified future date. These agreements are traded on exchanges for various underlying assets like commodities, currencies, or financial instruments. The primary function of futures contracts is to allow market participants to manage price risk or to speculate on future price movements. A common question arises regarding whether these financial instruments are subject to “time decay” in the same manner as other derivatives.

Understanding Time Decay

Time decay, often referred to as theta, describes the rate at which an option’s extrinsic value erodes as its expiration date draws nearer. Options derive their value from both intrinsic value, which is their immediate worth if exercised, and extrinsic value, which accounts for factors like volatility and the remaining time until expiration. The extrinsic value of an option diminishes daily because the probability of the option becoming profitable decreases with less time available for the underlying asset to move favorably.

This decay accelerates significantly in the final weeks or months before an option’s expiration, impacting its premium. For instance, an option with a theta of -0.05 is theoretically expected to lose five cents per day, assuming all other market conditions remain constant. This phenomenon means that holding options, especially as expiration approaches, can result in a loss of value even if the underlying asset’s price remains stable. The time value of an option eventually reduces to zero at expiration, leaving only its intrinsic value, if any.

Futures Contract Pricing

Unlike options, futures contracts do not experience time decay in the same way. Their pricing is primarily determined by the “cost of carry” model, which accounts for the expenses associated with holding the underlying asset until the contract’s maturity.

The cost of carry typically includes the spot price of the underlying asset, plus financing costs (interest rates) and any storage costs for physical commodities. Conversely, any income generated by the underlying asset, such as dividends for financial instruments, would reduce this cost. As the expiration date approaches, the time component of the cost of carry shortens, causing the futures price to converge naturally toward the spot price of the underlying asset. This convergence reflects the decreasing period over which carrying costs accrue, unlike the erosion of an option’s extrinsic value.

For example, a futures contract for a physical commodity like oil will incorporate the current spot price, the interest that could be earned on the money if the oil were purchased today and held, and the expense of storing the oil. As the delivery date nears, the cost of storing the oil for a shorter period decreases, and the financing cost also lessens. This adjustment leads the futures price to align with the current market price of the physical commodity.

How Futures Prices Change

Since futures contracts do not decay like options, their price movements are influenced by other market dynamics. Changes in the spot price of the underlying asset are a significant factor, as futures prices tend to move in tandem with the current market price. Fluctuations in interest rates also impact futures pricing, as they alter the financing component of the cost of carry. Higher interest rates can increase the cost of holding an asset, potentially raising futures prices relative to spot prices.

Supply and demand dynamics for the underlying asset play a considerable role in determining futures prices. An anticipated shortage or surplus can lead to significant price adjustments in futures contracts. Geopolitical events, economic data releases, and other news impacting the underlying market can also cause prices to fluctuate. The concepts of contango, where futures prices are higher than the spot price, and backwardation, where futures prices are lower, reflect market expectations regarding future supply and demand and carrying costs, further influencing price movements.