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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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As it turned out, Salesforce.com blew away expectations and jumped some 10% following earnings, so an owner of calls enjoyed a nice profit. However, if Salesforce.com shares rose just 3% after earnings, an owner of calls would have actually lost money since the increase in the stock price wasn't sufficient enough to offset the expected decline in implied volatility.

A great free site that offers an option calculator, and historical and implied volatility readings over various time periods can be found here.

Time Is Square, Man

There's a basic math formula used in the Black-Scholes model which is a good starting point for understanding the rate of decline in an option's value due to the passage of time, also knows as time decay or theta. Basically, we use the square root of time to calculate and plot time decay. The math involved in the nitty-gritty of evaluating theta can be extremely complex, so focus on this: Time decay accelerates as expiration approaches.

For example, if a 30-day option is valued at $1.00, then the 60-day option would be calculated as $1 times the square root of 2 (2 because there is twice as much time remaining). So all else being equal, the value of the 60-day option is $1.41, or $1 times 1.41 (1.41 is the square root of 2). A 90-day option would be $1 times the square root of 3 (3 because there is three times as much time remaining) for an option value of $1.73. (1.71 is the square root of 3).
No positions in stocks mentioned.

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