How Does the Concept of “Extrinsic Value” Relate to Theta Decay?

Extrinsic value, also known as time value, is the portion of an option's premium that exceeds its intrinsic value. Theta decay is the process by which this extrinsic value erodes over time.

As the option approaches expiration, the uncertainty about its final value decreases, and the time value disappears, eventually reaching zero at expiration. Theta measures the daily rate of this erosion.