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The 6-Week Options Trading Kickstarter: Options Pricing Basics

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Steve Smith breaks down the basics of options pricing.

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But given that options trade regularly, there is already an "actual" implied volatility assigned to each option based on its price, which is constantly updating in real-time. Therefore, our mission, should we choose to accept it, is to determine whether an option's current price looks cheap or expensive based on its volatility level.

Let's go over exactly what implied volatility is. Implied volatility is a measure of the probability of a certain percentage price move occurring within a given time frame. It is typically anchored to the underlying stock's historical or realized volatility, which measures recent price action.

A notable exception would be biotechs since shares of these names can trade rather benignly for months on end, while the prospect of volatility-inducing events, like FDA rulings, keeps implied volatility at elevated levels. For example, the 30-day historical volatility (or HV) of Dendreon (NASDAQ:DNDN) is 79% while the current implied volatility stands at 115%, suggesting that traders are pricing in the possibility of a substantial move.

By comparison, JPMorgan (NYSE:JPM) has a 30-day HV of 41% while the current implied volatility is just 29%. This "discount" of IV below HV would indicate that expectations for a big stock move are settling down following the hooplah over the big trading loss.

Now let's look at how understanding historical volatility can be used to counter the "options don't work" argument put forth by naysayers who get frustrated when they make an options bet and are correct on the direction of the underlying, but don't make money.
No positions in stocks mentioned.

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