Theta is a sensitivity measure that determines the decline in this extrinsic value of the option over time.
To understand theta, we need to first know the difference between the intrinsic and extrinsic value of an option. Together, the extrinsic and intrinsic value make up the total value or premium of an option.
Option Value = Intrinsic Value of Option + Extrinsic Value of Option
1) The intrinsic value measures the profit of the option based on the strike price and market price.
2) The extrinsic value measures the part of the premium not defined by the intrinsic value. The extrinsic value is the value of being able to hold the option and the opportunity for the option to gain value as the underlying asset moves in price. The closer an option is to expiration, the smaller the extrinsic value becomes.