Unit 2 · Level 1 · Pricing intuition
Melting ice cubes
Extrinsic value is a melting ice cube. Every day that passes, there's less time for 'what could happen', so that part of the premium shrinks. The greek for this daily melt is THETA. And the melt is cruel: it isn't steady. It accelerates as expiry approaches, dripping slowly with months left and gushing in the final weeks.
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What you get asked
All else equal, what happens to an option's extrinsic value as expiry nears?
By expiry, only intrinsic value remains: possibility has run out. And the melt curve steepens near the end, it doesn't run flat.
The greek that measures daily time decay is called ___.
Theta is quoted as value lost per day, all else equal. A theta of −€0.05 means the option is €0.05 cheaper tomorrow just for existing.
Put this slow-motion loss in the right order.
Nothing went 'wrong'. The stock didn't even fall. Doing nothing is enough for an OTM option to die; that's what paying pure extrinsic value means.
Who collects the value that time decay melts away?
Options are a two-sided market: the buyer's theta bill is the seller's daily income. That's why 'selling premium' is a whole style of trading.
Why 'melting ice cube' rather than 'leaky bucket'?
A small cube melts faster than a big block, and an option with days left sheds value faster than one with months. Holding short-dated options means renting the fastest-melting ice. 🐜
The rest of this unit
Intrinsic, extrinsic, theta and IV: what a premium is really made of.