Time Decay generates Cost & Compensation for Realized Risk.
Depending on the type of option position you are in, you will either pay, or be paid, to hold that position. But why would this position be generating cost or compensation to you? The answer is because you are realizing risk just by holding the position; that is, you are absorbing the movement of the stock price.
The second bar from the right shows that $40 of compensation has been generated over the same time period in which the trader absorbed a $35 loss due to the stock's movement. Notice that the compensation exceeds the $35 loss caused by the "primary risk" of the stock's movement. The trader has been over-paid for the realized risk of the stock's movement. But from where is this $40 of compensation coming? It's coming from the decay of the option's time value.
Often times, traders look at time decay in a "stand alone" manner. They reason, "If I hold this position until expiration I'll make $1,000 from decay!" This view is problematic for a couple of key reasons, which are explained below.
Problem #1: Cost or Compensation for realized risk (i.e., decay P&L) is not being viewed in the context of the actual realized risk. After all, you must realize risk (i.e., absorb the movement of the underlying stock price) in order to make or lose money from decay. The idea that one is "making a lot" from decay is entirely relative to the amount of risk the position has actually (not theoretically) realized from the stock's movement. Bear in mind that there's nothing saying how much risk has to be realized, nor whether it will come in the form of profits or losses. $1.00 of decay profits might be great compensation if the stock's movement has generated $100 in profits. It's all relative.
Problem #2: The Greek "theta" is likely being used to theoretically project the total decay compensation at expiration (we talk about the pros and cons of theta, and all the Greeks, in the next section.) For the moment, we'll say that there is often a failure to consider that theta is inversely related to gamma. Simply put, if the position looks like it will compensate you handsomly for realizing risk, it's because the market is expecting a lot of movement in the underlying stock; that is, it is expected that the position will realize a lot of risk.
