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Keeping up with the value of an option can be challenging. You’ve got the intrinsic value, which changes as the stock’s market value changes, and you have extrinsic value, which at first seems to change mysteriously and unpredictably. In this post, we’re going to get into the weeds and try to demystify the changes you see in extrinsic value by looking at the factors that affect extrinsic value: time until expiration, price of the underlying, and volatility. First, let’s look at the option chain for a contract expiring on Friday of this week. We’ll look at Amazon this time and our chart now displays a different set of columns, because we will focus on the Theo Price:
The Theo (short for theoretical) Price is a tool we can use to estimate how changes in time until expiration, underlying price, and volatility will affect the market price of an option contract. Because the settings for Theo Price are all set to the current date of this writing, the current price of the underlying, and the current volatility, the Theo Price is simply the average of the bid and ask prices.
First, let’s experiment with the time till expiration by moving the calendar one day, to 8/22/2022.
Check out the 137 strike. The Theo Price on 21 August was $3.28. One day later, it is 2.97. The table below lists the Theo Price for each day of the coming week:
| Date | Theo Price | Change From Previous Day | % Change | |
| 8-22 | 2.97 | -0.32 | -9.75 | |
| 8-23 | 2.63 | -0.34 | -11.45 | |
| 8-24 | 2.24 | -0.39 | -14.83 | |
| 8-25 | 1.21 | -1.03 | -45.98 | |
| 8-26 | 0.92 | -0.92 | -76.03 |
The Theo price changes increasingly rapidly as expiration approaches. This is what traders are talking about when they speak of time decay. Another term they will often use is theta (Θ), the Greek letter which equates with the Latin letter ‘T.’
Next, let’s see how changes in volatility affect option prices. We’ll use today’s date and price, but contrast how increases and decreases in volatility affect the Theo Price. I’ll not post a screen capture. If you’re still interested in options, you might want to download a trading platform and try to learn how to perform this sort of analysis yourself.
| Volatility Change | Theo Price | |
| +1% | $3.34 | |
| -1% | $3.21 | |
| +5% | $3.60 | |
| -5% | $2.95 | |
| +10% | $3,93 | |
| -10% | $2.62 |
We will discuss volatility at length in future posts. We will defer on discussing how we might use changes in the underlying price to help in trade selection and management. For now, the take-away is that option prices fall as volatility falls and as expiration approaches.