The component of option value called Extrinsic Value = Time Value.
Options have value based on two components: intrinsic and e trinsic vale.
Intrinsic value is the portion of value attributed to an option if it’s strike price below the current market vale of the underlying asset.
For example if Tesla is trading at 100 dollars, an option with a strike price of 95 dollars has 5 dollars of intrinsic value. [ 100-95= 5]
The second component of option value is called the Extrinsic component, and it is a numerical or monetary representation of value of the number of days until the option expires worthless, its expiration date.
The extrinsic value of an option shrinks each day by the amount determined by dividing the extrinsic component value in dollars by the number of days left until the expiration date.
Example if a Tesla option has a strike price of 100, and the current market value of Tesla is one hundred, then the option has no Intrinsic value, and it’s price represents only Extrinsic or Time Value.
If the value or price of this option is 24 dollars and there are 24 days until expiration, then the first day we divide 24 dollars by 24 days, which equals one or one dollar which is subtracted from the number 24, leaving 23 dollars and that is the value or price of this option at the beginning of the next day. This process is repeated each day until the last day when the option is worth zero dollars.
This is a straightforward reduction in option price or value each day from 24 dollars to zero dollars. This reduction in price is call Decay or Time Decay.
Understanding Time Decay is a core principle to making money in options trading.
Theta
In options trading there is another term called Theta and it is defined as the rate of decay of Extrinsic or Time Value of an option. This means Theta is the amount by which an option loses value from its price each day.
Some people are called Theta Traders because they sell options high and buy them back low, and they depend on Theta to guarantee them a lower price.
Remember options buyers buy low and hope to sell high. But options sellers sell high and want to buy back low. Theta helps them do this consistently.
Theta is also called an option Greek, and we will discus the Greeks later.
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