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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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If you'll notice, the premium of the 60 day over the 90 day ($0.32) is less than that of the 60 day over the 30 day ($0.41). So again, the important takeaway is to realize that the closer an option gets to expiration, the rate at which time value decays gets faster.

Here are some other basic concepts you need to know about theta:
  • An options theta can be calculated as follows: If a particular option's theta is -10, and 0.01 of a year passes, the predicted decay in the option's price is about $0.10 (-10 times 0.01 is 0.10).
  • At-the-money options have the highest theta. Theta decreases as the strike moves further into the money or further out of the money. In-the-money options are mostly composed of intrinsic value (the difference between the strike price of the option and the market price of the underlying), while out-of-the-money options have a larger implied volatility component.
  • Theta is higher when implied volatility is lower. This is because a high implied volatility suggests that the underlying stock is likely to have a significant change in price within a given time period. A high IV artificially expands the time remaining in the life of the option, helping it retain value.
Just as it isn't necessary to know how to build an engine to drive a car, you don't need to know all the math behind the pricing of an option. But it certainly helps to understand the concepts that make them stop and go. And with experience, they'll safely take you where you want to go.

Here is a complete schedule for the 6-Week Options Trading Kickstarter:

1. What Are Options, and Why Should We Care About Them?
2. Options Pricing Basics
3. Meet the Greeks
4. How to use Options: Three Basic Principles
5. Covered Calls
6. Hedging, Portfolio Protection, and Avoiding Disaster

Twitter: @steve13smith

For more from Steve Smith, take a FREE 14-day trial to OptionSmith and get his specific options trades emailed to you along with exclusive access to his full portfolio. Learn more.
No positions in stocks mentioned.

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