One of the reasons we like to short option premium is because it places Theta (time decay) on our side. What we are effectively doing is selling extrinsic value. Does that mean that theta and extrinsic value are the same thing and if not what to the terms mean and how are they related?
Extrinsic value is the total value of time in an option. Theta is how much of that time value should theoretically decrease each day until expiration. An example of theta and extrinsic value in the August options with 53 days to expiration (DTE) and the $100 at-the-money (ATM) call with underlying XYZ stock trading for $100 was displayed. The example included the extrinsic value 0f 5.00 and theta decay on the option of 0.05. The theta means that the call should be worth $5.00 less each day all other things remaining the same.
Some simple math brings up a problem. The theta of 0.05 means that all else remaining the same the call should lose $5 of extrinsic value per day. There are 53 DTE. Multiplying 53 by 5 results in a product of $265 yet the extrinsic value is $500. What’s wrong here? The answer is that Theta is not static. It increases as expiration is closer. Tom and Tony mentioned questions from some viewers asking, given the above, why not sell options with much less time than our standard 45 DTE? They answered that there is increased risk (from Gamma) in the options closer to expiration.
An example of theta and extrinsic value in the August (53 DTE) $95 in-the-money (ITM) call with underlying XYZ stock trading for $100 was displayed. The example showed that the price was higher for ITM options, but the extrinsic value was lower, so theta is lower as well. Extrinsic value and theta both can change. Tom and Tony noted that it makes no sense to sell ITM or ATM options to open a position. When selling ITM options there is no increase of theta decay with time, there is actually a decrease. The preference is always to sell out-of-the-money (OTM) options closest to 45 DTE.
For more on Theta see:
Best Practices from April 27, 2016: "Differences Between Theta & Extrinsic Value"
Options Jive from May 20, 2016: "Theta Relationships"
Watch this segment of Options Jive with Tom Sosnoff and Tony Battista for the valuable takeaways and a better understanding of the relationship between theta and extrinsic value and how each works.
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