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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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Reverting to the Mean

Now let's look at how historical volatility can be used to avoid the "options don't work" argument put forth by naysayers who get frustrated when they make an options bet, are correct on the direction of the underlying, yet don't make money.

Keeping with Salesforce.com, ahead of its February 24 earnings report, implied volatility climbed up to 50%, which was well above the then 32% rate at which the 30-day historical was running. This was because the options market was pricing in the 7% price move that the shares had averaged over the past four earnings reports.

The down-and-dirty way to gauge what the options market is pricing is to look at the straddle and revert the IV back to the mean. (I will elaborate further on this in an upcoming piece on trading earnings and other special situations.) An increase in implied volatility ahead of an event is simply the expression of a higher probability of a larger-than-usual price move within a given time frame. In this sense, an increase in implied volatility is an artificial expansion of time. In other words, what could happen over a long period of time is now being priced into a shorter period of time.

Understanding where IV stands relative to HV, and why it is at the current level is crucial to valuing current option prices and anticipating future moves. If a volatility-inducing event is anticipated -- like with an earnings report -- 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. So regardless of what happened, one should expect that IV on Salesforce.com options would revert toward the mean of around 35% following the report. This means one would need at least a 6% price move to break even. (Note: This is not 7% because the options would still retain some time value. This is part of an extended discussion beyond the scope of this article.)
No positions in stocks mentioned.

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