Theta

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ThetaTheta represents how much an option’s price will decline due to the passage of time.The value of an option is made up of intrinsic plus extrinsic value. Intrinsic value is the difference between the strike price and market price of the underlying security, when the option is “in-the-money.” Extrinsic value is made up of the time value and implied volatility of an option. Theta focuses on time value and assumes implied volatility remains constant.As time approaches expiration on an option, that option’s extrinsic value decreases. Theta is a measure of how much that extrinsic value is decreasing as the option approaches expiration.For example, assume an investor owns a put option for Stock ABC with a strike price of $20. ABC’s market price is $25. The option’s price was $2 and it expires in ten days. This option has no intrinsic value since it is not “in-the-money.” Its value is coming from its extrinsic value. As the option approaches its expiration, its extrinsic value will decrease. Theta will tell us by how much. Assume in this case, the Theta value is -.10. As the expiration date gets closer, the value of the option decreases by $0.10 per day. If eight days pass by, then the value of the option would decrease by $0.80. Now, the option’s price will be $1.20.