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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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Understanding where IV stands relative to HV, and why it is at the current level is crucial to assessing current option prices, and anticipating future moves.

If a volatility-inducing event like an earnings report is anticipated, implied volatility will revert back to the mean after the event. But if there is unanticipated news like a surprise FDA ruling on a drug, IV will spike.

With Fusion set to report earnings on August 9, expect implied volatility to start to creep up in coming weeks -- and then expect it to drop back towards 50%, or close to historical volatility, immediately following the report.

One site that offers an option calculator and historical and implied volatility readings over various time periods is iVolatility.com.

Time Is Square, Man

There's a basic math formula used in the Black-Scholes model that is a good starting point for understanding the rate of decline in an option's value due to the passage of time (also known as time decay or theta). Basically, we use the square root of time to calculate and plot time decay. The math involved in the nitty-gritty of evaluating theta can be extremely complex, so focus on this: Time decay accelerates as expiration approaches, meaning that theta is defined on a slope.

For example, if a 30-day option is valued at $1.00, then the 60-day option would be calculated as $1 times the square root of 2 (2 because there is twice as much time remaining). So all else being equal, the value of the 60-day option is $1.41, or $1 times 1.41 (1.41 is the square root of 2). A 90-day option would be $1 times the square root of 3 (3 because there is three times as much time remaining) for an option value of $1.73. (1.71 is the square root of 3).
No positions in stocks mentioned.

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