Is there a difference between Theta and Extrinsic value? If so, what is that difference? Both are measurements of time value but do they refer to the same thing?
Extrinsic value is the time value of an option. There is no extrinsic value in an option at expiration. An example would be an at-the-money (ATM) call. You are trading options in SPY (S&P 500 ETF), which is currently at $208.00. The June $208 calls are trading for 5.00, which is all extrinsic value because the option would be worth nothing at expiration if SPY remained at $208.
Theta is related to extrinsic value, but different. It is how much, according to the option model you are using, extrinsic value will decrease by each day until the option expires. Using our SPY example above, the June $208 calls have 53 days to expiration (DTE) and are exactly ATM with $5.00 in extrinsic value. The Theta for these calls is 0.05, which means it would take 100 days for the extrinsic value to disappear when using straight-line depreciation based on theta. The reason for the discrepancy is that Theta increases as expiration approaches. Assuming everything remains the same, the call will lose more extrinsic value as time progresses. That is the benefit to option premium sellers.
One last thing to consider is how extrinsic value disappears as an option gets deeper and deeper in-the-money (ITM). The June $208 calls in SPY with SPY at $208 are trading at 5.00, which, of course, means they have 5.00 in extrinsic value. If the $207 call is trading for $5.50, it only has $4.50 of extrinsic value because its intrinsic value is $1.00.
For more information on Theta and Extrinsic Value see:
The Skinny On Options Math from February 26, 2015: “Higher Theta”
Options Jive from July 31, 2015: “Theta”
Market Measures from December 17, 2015: "What’s The Deal With Premium?”
Options Jive from January 22, 2016: “Extrinsic Value Explained”
Options Jive from March 7, 2016: “Not All Options Decay The Same”
Watch this segment of “Best Practices” with Tom Sosnoff and Tony Battista for the important takeaways and a better understanding of the relationship and differences between Theta and extrinsic value.
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