How Does the 'Square Root of Time' Rule Apply to Options Pricing? ⎊ Path

How Does the ‘Square Root of Time’ Rule Apply to Options Pricing?

The 'square root of time' rule is a principle derived from the Black-Scholes model, stating that the volatility of an asset's price movement scales with the square root of time. In options pricing, this means that an option with four times the time to expiration will have twice the expected volatility, and thus a significantly higher extrinsic value.

This rule highlights the non-linear relationship between time and an option's premium, explaining why the extrinsic value decay is faster closer to expiration.

Why Is a Deep ‘Out-of-the-Money’ Option’s Premium Composed Entirely of Extrinsic Value?

What Is the Relationship between an Option’s Premium and Its Extrinsic (Time) Value?

Why Is a Futures Contract Considered a Linear Derivative While an Option Is Non-Linear?

How Does the ‘Moneyness’ of an Option Affect Its premium’S’extrinsic Value’?

Define “Intrinsic Value” and “Extrinsic Value” of an Option

How Does Increasing Volatility Affect the Premium of Both Call and Put Options?

How Does the Premium Relate to the Intrinsic and Extrinsic Value of an Option?

What Are the Main Components of an Options Premium (Intrinsic and Extrinsic Value)?

Glossar

Square Root of Time

Analogy ⎊ A mathematical relationship used in option pricing models where the rate of time decay (Theta) is inversely proportional to the square root of the time remaining until expiration, illustrating accelerated decay near zero time.