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9 Weeks to Better Options Trading: An Options Pricing Primer

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Veteran options trader Steve Smith breaks down the concepts of implied volatility and time decay.

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Editor's note: To help investors profitably navigate the options market, Minyanville is launching "9 Weeks to Better Options Trading," an educational series aimed at increasing trader understanding of the nuts and bolts of options, with an emphasis on real-world applications. In this series, veteran options trader and author of OptionSmith (Click here for a two-week FREE trial and get Steve's best trading ideas in real time) Steve Smith will demystify a range of topics from options pricing to trading strategies to special situations like earnings reports and takeovers.

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:

1. The price of the underlying security

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.
No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

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