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.
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).
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