Theta
Option prices can be broken down into two parts: intrinsic value and time
value. Intrinsic value is easily measurable. It is simply the ITM part of the
premium. Time value, or extrinsic value, is what’s left over—the premium
paid over parity for the option. All else held constant, the more time left in
the life of the option, the more valuable it is—there is more time for the
stock to move. And as the useful life of an option decreases, so does its time
value.
The decline in the value of an option because of the passage of time is
called time decay, or erosion. Incremental measurements of time decay are
represented by the Greek letter theta (θ). Theta is the rate of change in an
option’s price given a unit change in the time to expiration . What exactly is
the unit involved here? That depends.
Some providers of option greeks will display thetas that represent one
day’s worth of time decay. Some will show thetas representing seven days
of decay. In the case of a one-day theta, the figure may be based on a seven-
day week or on a week counting only trading days. The most common and,
arguably, most useful display of this figure is the one-day theta based on the
seven-day week. There are, after all, seven days in a week, each day of
which can see an occurrence with the potential to cause a revaluation in the
stock price (that is, news can come out on Saturday or Sunday). The one-
day theta based on a seven-day week will be used throughout this book.