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.
Here are some other basic concepts you need to know about theta:
- An options theta can be calculated as follows: If a particular option's theta is -10, and 0.01 of a year passes, the predicted decay in the option's price is about $0.10 (-10 times 0.01 is 0.10).
- At-the-money options have the highest theta. Theta decreases as the strike moves further into the money or further out of the money. In-the-money options are mostly composed of intrinsic value (the difference between the strike price of the option and the market price of the underlying), while out-of-the-money options have a larger implied volatility component.
- Theta is higher when implied volatility is lower. This is because a high implied volatility suggests that the underlying stock is likely to have a significant change in price within a given time period. A high IV artificially expands the time remaining in the life of the option, helping it retain value.
For complete access to Steve Smith's OptionSmith portfolio, which returned 28% in 2011, click here.
Here is a complete schedule for "9 Weeks to Better Options Trading":
Week 1: 5 Rookie Mistakes Options Traders Make
Week 2: Option Pricing Basics: Understanding Implied Volatility and Time Decay
Week 3: Trading Strategy: Calendar Spreads
Week 4: Trading Strategy: Butterfly Spreads
Week 5: Trading Strategy: Iron Condors
Week 6: Trading Strategy: Risk/Reversals
Week 7: Trading Strategy: Back Spreads
Week 8: Managing Risk
Week 9: Special Situations: Earnings Reports, Takeovers, and Extreme Market Moves
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