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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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If you notice, the premium of the 60 day over the 90 day ($0.32) is less than that of the 60 day over the 30 day ($0.41). So again, the important takeaway is to realize that the closer an option gets to expiration, the rate at which time value decays gets faster.

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.
Next week, when we discuss calendar spreads, I'll drill down into isolating theta or decay, and how to transform it from a drag on performance to a tailwind.

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
No positions in stocks mentioned.

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