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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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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's historical volatility, which measures recent price action.

A notable exception would be in biotechs such as Dendreon (NASDAQ:DNDN) or Biogen (NASDAQ:BIIB). 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. And more related to our current events, options on banks like JPMorgan (NYSE:JPM) and Bank of America (NYSE:BAC) have implied volatilities that are premiums to historic levels because of ongoing worries over exposure to Europe and other issues.

Let's look at the April at-the-money calls in two very different types of stocks. Salesforce.com (NYSE:CRM), a high-octane momentum stock which regularly makes massive price swings, has a current 30-day historical implied volatility (HV) of 38%. On the other hand, the relatively staid and less-exciting utility Consolidated Edison (NYSE:ED) currently has a 30-day HV of 11%. But which one's options are cheaper?

Salesforce.com is the obvious answer, but to be sure, let's look under the hood at implied volatility readings. Salesforce.com's April $135 call has an implied volatility of 35%, carrying a three-percentage-point, or 5.7% discount to HV. On the other hand, Con Ed's April $57.50 calls carry a 12.5% implied volatility, which is a 1.5-percentage-point, or 14% premium to HV. So at this point, I would say Salesforce.com's options, which trade at a discount, are cheaper than Con Ed's, which trade at a premium.
No positions in stocks mentioned.

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