9 Weeks to Better Options Trading: An Options Pricing Primer
Veteran options trader Steve Smith breaks down the concepts of implied volatility and time decay.
For the first article in the series, click here.
If you are a novice options trader, we suggest you start with Steve Smith's 6-Week Options Trading Kickstarter series.
We are now on the second week of our nine-week journey into the world of options, and now that we've got some of the basics out of the way, it's time to jump into options pricing.
So what do former NBA star Allen Iverson and implied volatility have in common? They have both been labeled “The Answer.” While Iverson has been more of a question lately (how exactly did he spend that $100 million+?), implied volatility remains the key to answering the number-one question on an option trader’s mind: Is this option “cheap” or “expensive”?
The most commonly used apparatus for valuing options is the Black-Scholes model, which considers five factors in calculating a particular option’s theoretical fair value:
2. The strike price
3. The time, or expiration date of the option
4. Interest rates
5. Implied volatility
The first four inputs are known variables. To get number five, we plug those four inputs into the Black-Scholes model. This would give us “theoretical” implied volatility, which helps us answer our big question above. 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.
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