FULL Beginner Guide to Option Profitability (tasty Mechanics, Extrinsic Value, Option Greeks)

Option pricing is central to everything that you do as a trader. You want to buy options; you need to understand option pricing. You want to sell options; you need to understand option pricing.

You want to understand how you can sell a put spread, have the stock actually go down, and still make money; you need to know how to interpret and apply option pricing. So, for the next 45 minutes, that's exactly what we're going to do. We're going to focus exclusively on this one critically important area.

But before we dive in, if you're watching this on YouTube, be sure to add this video to your "Watch Later" playlist. That way, if you take breaks along the way, you won't have to give up on your journey just because you can't find the video in your browsing history. It will be saved in that "Watch Later" playlist.

But all right, without further ado, let's do it, man! Let's dive right into the option pricing crash course. Hey, Jim Schulz here with you guys for the Tasty Live Network, excited to get into another brand new crash course right here, right now, on option pricing.

Now, if you've already seen some of the other crash courses that we have on the website or on the YouTube channel, the reality is this: a lot of what we cover in this crash course is going to overlap with the content in those other crash courses. But option pricing is so central; it's so fundamental to everything that we do with all of our strategies. I really felt that a dedicated, concentrated crash course on option pricing specifically would still be very useful.

And also, quick disclaimer—or maybe second disclaimer at this point—this crash course is not really designed for a true beginner. I am going to be skipping over some things that I'm just going to assume you understand and that you have at least a reasonable handle on when it comes to some of the beginner concepts. I would check out the full 2023 options crash course that we already have on the network and on the YouTube channel for more of a beginner angle.

All right, so without further ado, let's do it, man! Let's dive right into episode number one of the option pricing crash course, and let's start by talking about the two sides to the option contract. So, every option contract has two sides and a host of standardized variables.

Now, we're going to get into the two sides of the option contract in just a second, but let's start by taking a closer look at some of the variables of the option contract, and let's begin with the variables that are fixed over the life of the option. You have the underlying stock, you have the strike price, you have the quantity of shares of the contract, and you also have the expiration date. The underlying stock, you have an option contract in Microsoft; it's going to stay in Microsoft.

You have an option contract in McDonald's; it's going to stay in McDonald's. Easy enough. The strike price, whatever the strike price or eventual transaction price in the stock is at contract origination, it's going to remain fixed over the life of the trade.

So, if the strike is 25, or 50, or 100, or whatever, it's going to stay at 25, or 50, or 100, or whatever, all the way until expiration. The quantity of shares? This one is super simple: standard options are always for 100 shares in the underlying stock.

And the expiration date is usually set to the third Friday for regular monthly options, but there are also weekly expiration cycles and even zero DTE cycles in some of the major indexes like SPY and QQQ, at least as of this recording. Whatever it is, the expiration date is fixed over the life of the option. Okay, those are all fixed, but arguably the most important variable associated with any options contract is very much not fixed: the option price itself.

So, in regards to the options price, I mean something we're going to now spend the next, you know, 45 to 60 minutes on inside of this crash course. There are really two ways that you can think of an options price, both of which have their merits and their usefulness. You can think of an option price from a theoretical standpoint, or you can think of an option price from a practical standpoint.

Let's start with the theoretical angle. So, option prices are determined by what are referred to as option pricing models, with the most famous option pricing model being the Black-Scholes option pricing model that was developed back in the early 1970s. Essentially, what an option pricing model does is it takes a set of known variables in the marketplace and uses those variables to compute what the theoretical price of the option contract should be based on those inputs.

Specifically, if we know the underlying stock price, the strike price of the contract, the implied volatility, the expiration date, any dividends paid, and the risk-free rate at that time, getting to an option's price becomes a fairly straightforward process of inputting these variables into the model, cranking through the math, and voila, you have the theoretical fair value of the option's price. All right, easy enough. But options are living and breathing things; the financial markets are living and breathing things.

They may not necessarily respond exactly as they should respond given some theoretical equilibrium point established by a model in a vacuum, not to mention the implied volatility itself is something that is not known by the market; it needs to be estimated. So, you have at least a little bit of wiggle room there too. But I digress.

As a result, while theoretical option prices. . .

will always be established by these mathematical models that do a very good job. Mind you, real option prices are going to respond to the realest thing that you would ever see in the markets: order flow itself. And it's very simple; it goes back to the basics of supply and demand.

If there is more demand for an option, its price is going to rise. If there is more supply of an option, its price is going to fall. So, in the end, if you want to marry these two things together—the theoretical side and the practical side—you can think of it this way: the theoretical side sets the initial equilibrium price of an option contract, and then the practical side takes it from there with the natural forces of supply, demand, order flow, etc.

All right, so with that foundation, let's now turn our attention back to the two sides of the option contract. Each option contract has two sides: the buyer and the seller. You can enter the contract on either side; you can choose to be the buyer, or you can choose to be the seller.

It is 100% up to you at trade origination. Now, it's very important to recognize that there are some synonyms that go along with the two sides of the contract. On the buy side, you could also say that you are long that option, or you could say that you own that option.

So, buy, long, own—those are all synonymous. On the sell side, you could also say that you are short that option, or you could say that you wrote that option. Those are all effectively synonymous as well.

Selling, short, and writing—essentially, the three synonyms on the two sides are often used interchangeably. So, you want to be well-versed with this terminology so that you can follow along with trading content and conversations. Okay, easy enough, but next up: two very important things.

First, options are often referred to as what is called a zero-sum game. So, what this means is that whatever one side of the contract wins, the other side of the contract loses, and vice versa. So, if you determine the profits on one side of a contract, you have indirectly also determined the losses on the other side of the contract.

Second—and I’ve been teaching derivatives for nearly 20 years now—the best way—and it is not even close—to think about the option contract, the relationship between the buyer and the seller, and all those kinds of things is the following: think in terms of the long side buying the contract from the short side. Now, when you bring in Marketplace dynamics and market makers and liquidity providers and all those things, it's more complicated than that; it's not quite that simple. But when you start to think about the contract and consider option pricing itself, it is so useful to simplify the process down to that one singular basic component: the long side buying the contract from the short side.

You’re not too far from reality; that's going to completely mess up the spirit of what actually happens in the marketplace, and it is going to make things much, much simpler for you to understand the contract, option pricing itself, and all the things that we’re trying to do inside of this specific crash course. Okay, so now that we have a decent foundation of the option contract itself—something that is absolutely necessary to understand option pricing—one final thing before we bring episode number one to a close: in the option world, there are two basic option types: call options and put options. The basic difference is this: call options give the long side the option to buy shares from the short side of the call at the strike price; put options give the long side the option to sell shares to the short side of the put at the strike price.

And remembering that the strike price is fixed over the life of the contract—something that we established a couple of minutes ago—my hope is that it’s somewhat clear to see that the long side of a call option is bullish. They want the stock price to rise above the strike price so they can buy it at that lower strike price and lock in an instant gain. Similarly, the long side of a put option would be bearish; they want the stock price to fall below the strike price so they can sell it at that higher strike price and lock in an instant gain there.

And, if we recall that options are a zero-sum game—something that we addressed about 35 seconds ago—then we can easily extrapolate that if the long side of the call is bullish, the short side of the call must be bearish; and if the long side of the put is bearish, the short side of the put must be bullish. That is 100% correct and a great foundation for understanding these relationships. Now, if you are a beginner trader, you might be thoroughly confused at this point.

Sure, you got the contract down; you got the specifics down—the two sides and all of that—but all that info that I just dropped on your doorstep with calls, puts, strikes, bullishness, and bearishness, you might want to call a bit of an audible at this point. Go back and check out that 2023 full options crash course; that would be a very, very good thing for you to do right now if you are a little bit lost as to some of the things that I said a couple of minutes ago with calls and with puts and with bullishness and with bearishness. But if you feel okay with the base that we kind of laid down.

. . And skipped over with calls and puts and things like that.

What I want to do now is get into the next episode where we bring in a very important component to what we're trying to do, which is money, because once you have calls and you have puts and you have moneyness, you can establish the building block to all option pricing: intrinsic value. So, I'll see you inside. Jim Schultz, back with you guys for episode number two of the option pricing crash course.

Back in episode number one, we just laid down the basic foundation: the contract, the variables, the two sides. We even scratched the surface a little bit on call options and put options and bullishness and bearishness. Here in episode number two, we're going to pick up right where we left off.

So let's do it! Let's dive right into episode number two of the option pricing crash course. So, at its core, option pricing is actually quite simple.

It only has two pieces: if you understand these two pieces, then you understand option pricing: intrinsic value and extrinsic value. These are the only two puzzle pieces to the puzzle that is option pricing. Now, in this episode—episode number two—we're going to cover intrinsic value, and then in the following episode—episode number three—we're going to cover extrinsic value.

Now, thankfully for our work here right now, intrinsic value is pretty simple and pretty straightforward. Essentially, intrinsic value measures the immediate worth of the option contract to the long side of that contract. In other words, does having the option contract give the long side some clear value relative to what they would have if they just held the stock?

If the answer is yes, you have intrinsic value; if the answer is no, you do not have intrinsic value. So, let's look at some simple examples. Remembering back to the option contract basics from episode number one, we recall that with a call option, the long side has the opportunity to buy the stock at the strike price over the life of the trade, and with a put option, the long side has the opportunity to sell the stock at the strike price over the life of the trade.

So, suppose we were looking at a call option in Apple with a strike price of $190. If Apple were at $195, then this contract has immediate value to the long side of that contract—the long call holder—because he could buy Apple at $190, the strike price, when it's actually worth $195, the current stock price. Therefore, this option contract has intrinsic value.

Conversely, however, if Apple were at say $175, then this contract would not have immediate value to the long side and thus would not have any intrinsic value. I mean, why buy Apple at $190 with your call contract when you can buy it at $175 in the open marketplace? Now, suppose we're looking at a put option in Starbucks with a strike price of $100.

If Starbucks were at $90, this contract, too, would have immediate value to the long side of that contract—the long put holder—because he could sell Starbucks at $100 when it's only worth $90. So, if he already owned the shares, he could sell them for $100 when they’re only worth $90. There’s immediate value there!

Or, if he didn't even own the shares, he could just go out and buy them at $90 and then exercise his put option to sell them at $100, again producing immediate value. Both instances give the long put holder an immediate gain. Conversely, however, if Starbucks were at $115, then this contract would not have immediate value to the long side and thus would not have any intrinsic value.

To be clear, why exercise your put option to sell Starbucks at $100 when you could just sell it at $115 in the open marketplace? So, that's intrinsic value: pretty simple and straightforward. If there is immediate value to the long side, you have intrinsic value; if there isn't, you don't.

To go one step further, the amount of immediate value that the contract might bring is indeed the amount of intrinsic value that you would have in the option price. To better understand this idea, we now need to introduce the idea of moneyness. So, let's take a look.

There are three states of moneyness: in the money, out of the money, and at the money. These different states directly connect the examples we just went through with the idea of intrinsic value. A call option is in the money if the stock price is above the strike price, and a put option is in the money if the stock price is below the strike price.

So, in other words, call options and put options are in the money if they provide the long side of the contract with immediate value. A call option would be out of the money if the stock price is below the strike price, and a put option would be out of the money if the stock price is above the strike price. In other words, call options and put options are out of the money if they do not provide the long side of the contract with immediate value.

Lastly, a call option or put option is at the money if the stock price is equal to the strike price. So, what this means is this: if an option is in the money by $12, it has intrinsic value of $12—call or put, it doesn't matter. If the option isn’t in the money (so either out of the money or the rare instance of at the money), then it doesn’t have any intrinsic value; its intrinsic value is zero.

And that's it—that’s the first piece to the option pricing puzzle: intrinsic value. It's some positive number, or it's zero. It is the first building block to understanding an option's price because an option will always sell for at least the amount of intrinsic value that it has.

But remember, there's another piece to the option pricing puzzle: extrinsic value. Thankfully for you and me, that is coming up in the very next episode, episode number three. So, I will see you there.

Hey, Jim Schultz back with you guys for episode number three of the Options Pricing Crash Course. Back in episode number two, we covered the first piece to the option pricing puzzle: intrinsic value. Here in episode number three, we're going to cover the second and final piece to the option pricing puzzle: extrinsic value.

So let's do it! Let's dive right into episode number three of the Options Pricing Crash Course. To kick things off today, I want to lean on the talented crew that we have on the Tasty Research Team.

Here is Anton, giving us a really nice foundation of how to begin thinking about extrinsic value. Extrinsic value is an options concept that explains why certain options are more expensive than others, regardless of the value that the underlying stock is trading at. This is useful for deciding if we want to buy or sell an option.

The way I think of extrinsic value can be summarized in the following two points: Number one: An option's extrinsic value takes into account each underlying unique implied volatility and combines it with the known variables like the price of the stock, the strike price of the option, and the time to expiration. The higher the extrinsic value, the more the stock has to move to retain any value by expiration. Number two: Intuitively, extrinsic value is an average market expectation of what the option could be worth in the future, whereas intrinsic value is the known value of the option today.

Keeping these two points in mind, we have to decide if we want to buy options or sell options. Over time, this is where the research comes in. Over time, if we take the price of an option six weeks from expiration and compare that to the average price of the option at expiration, we see that nearly all options are cheaper at expiration, even after taking into account all the market action.

This means that the extrinsic value is usually priced higher than the stock's actual movement. If we're trading options as investors, then we want to be on the side that's typically profitable: the seller side. And that is exactly right—extrinsic value is usually priced higher than what actually happens in the stock, what actually materializes in the marketplace.

As option sellers, we can take advantage of that. So, let's build on this empirical finding from the Tasty Live Research Team and bolster up our understanding of extrinsic value. To do so, not surprisingly, let's begin with the relationship between the option buyer and the option seller.

Option buyers want option prices to move higher, and as high as possible for that matter. So, they always want both intrinsic value and extrinsic value to be as high as possible. Option sellers, however, want option prices to move lower, with zero being the lowest and best possible point.

So, they always want both intrinsic value and extrinsic value to be as low as possible. Understanding what we understand now about the option contract and how we determine intrinsic value, given its relationship to money, these are pretty straightforward expectations. Still, it's important to remind ourselves of the different perspectives of the option buyer and option seller as we look at a few different factors that impact extrinsic value specifically.

Essentially, there are three different main factors that drive extrinsic value: there's time, there's volatility, and there's the relationship between the stock price and the strike price. Now, we could dive into an option pricing model, and we could show all this and illustrate all this mathematically, but I actually want to go a different route. Let's try to understand this intuitively using only what we've learned inside of this very crash course.

I mean, the mathematics are great; without them, we would not be having this conversation. But for most of us, what's going to help us in the moment, real time, when we're making decisions in the real live markets, isn't whether or not we can differentiate the Black-Scholes model with respect to price or time or whatever it's going to be. It's going to be whether or not we can correctly identify and interpret the key relationships between the important metrics in the marketplace and how they might apply to our positions, our portfolio, and all of those things.

So let's take a closer look at time, volatility, and the relationship between the stock price and the strike price, starting with time. The relationship between time and extrinsic value is actually fairly simple, especially when you think of an option contract in terms of the option buyer buying the contract from the option seller. Whenever you increase time, all other things being equal, you increase extrinsic value.

Whenever you decrease time, all other things being equal, you decrease extrinsic value. Working through this from the vantage point of the two sides to the contract should make this obvious to you. Remember that an option buyer, call or put, it doesn't matter, has a limited risk position with the potential for effectively unlimited gains.

If the stock goes against him, he would lose the premium he paid for the contract and no more. But if the stock goes for him, there is essentially no cap on how much he could potentially make on the position, even though technically, stocks can only fall to zero. So that does put a theoretical cap on profits to the downside.

For the option buyer, more time adds greater return. Potential. Keep that in mind; that is very, very important.

On the other side of the contract, for the option seller, it's the polar opposite of that: he can only make limited profits with the potential for unlimited losses. If the stock goes in his favor, then he'll keep the premium he collected on order entry, but no more. If the stock goes against him, however, there is no limit to how much he could potentially lose.

Again, we see the zero-sum game nature of the option contract in action. So, for the option seller, more time adds more risk, and that is the key. Remember, the buyer buys the contract from the seller, but it is effectively the seller that determines the price he is willing to sell the contract for.

Therefore, contracts with more time will always have more extrinsic value and thus higher overall option prices; contracts with less time will always have less extrinsic value and thus lower overall option prices. To prove this to yourself, don't take my word for it. You can look at it for yourself: open up your Tasty Trade platform, pull up Starbucks, and grab any strike.

Compare the 45 days to go expiration cycle and the 21 days to go expiration cycle right now. You will always see more extrinsic value in the 45 days to go cycle relative to the 21 days to go cycle, just like you would see more extrinsic value in the 21 days to go cycle than you would see in the seven days to go cycle, and so on and so forth. All right, so that's time.

Let's now take a look at volatility's relationship with extrinsic value. Now that we have time's relationship with extrinsic value well established, volatility's relationship with extrinsic value isn't too bad. Mainly because the driving force behind this relationship is the risk to the short side of the contract, with potential losses for the long side limited and potential losses for the short side unlimited, it's easy to see that the short side is already taking greater risk than the long side.

But if you layer on top of that even more volatility in the underlying stock, that just adds even more risk to the short side of the contract. The reason why is the same as what we saw with time and option contract dynamics to begin with: if things don't work out, the long side can always just walk away with limited loss. For the short side, unfortunately, it's not that easy.

And if there's more volatility in the underlying stock, that means, by definition, that the stock is expected to move more wildly. Well, those wilder moves and larger fluctuations can allow the long side to benefit from these big moves and cash in on a large move in his favor. If that were to happen, that would mean the short side would be on the other side of that large move, absorbing larger losses.

Therefore, the short side is going to increase the price of an option contract on a more volatile stock, all other things being equal, to help protect him from all that added risk. And again, don't take my word for it; prove it to yourself. Open up your Tasty Trade platform, which at this point should already be open, and take a look at two stocks that have about the same stock price but relatively different implied volatilities.

You will always see in the same expiration cycle greater extrinsic value in the stock with a higher implied volatility for all the reasons that we just mentioned. All right, so we've covered time and we've covered volatility and how they impact extrinsic value. Now let's see how the stock price-strike price relationship also impacts extrinsic value.

So, the relationship between the stock price and the strike price is an important part of understanding extrinsic value, and a lot of what we'll see here in the next few minutes has to do with the relative distance between the two. So, that is why I like to refer to this relationship as simply the proximity effect. Now, that is just my own term; I just made that up to kind of describe this relationship.

But this proximity effect is a central component of the Black-Scholes option pricing model. So, a complete understanding of all that is happening with it is beyond what we're trying to do here. However, I do think that taking some time to understand some of the simpler implications of this effect can be really helpful in breaking down an option's price.

So essentially, what the proximity effect boils down to is this: does where the stock is right now make it more or less likely that it will go from being out of the money to in the money relative to some other point? Remember that option sellers are taking all the risk, and option sellers are especially hurt by options that go in the money because that is when the option starts building up intrinsic value—something we learned in the last episode. So, option sellers are going to be keenly aware of where a stock price is relative to their strike price to best assess the risk of that option going in the money.

As a result, what we see is that at-the-money options always have the most extrinsic value, or in other words, the option seller is charging the highest possible premium to take the short side of an at-the-money contract. Why is that? Well, one reason is what we just learned: an at-the-money option is literally on the cusp of being in the money.

So, to guard against that additional risk, the option sellers are going to charge the most extrinsic value that they possibly can. Here, I would say the proximity effect is at its strongest point. Now, what happens when you.

. . Start moving out of the money.

What you will see is the extrinsic value drops off from that at-the-money level, and it drops off more and more the further you move out of the money. Or, in other words, the proximity effect is getting weaker and weaker and weaker. It's a complicated thing, the proximity effect, I know, but again, don't take my word for it.

Look at any stock in the same expiration cycle and study the extrinsic value differences when you move from the at-the-money strike to the out-of-the-money strike. You will see extrinsic values falling every single time; that's the proximity effect in action. Wow!

And just like that, somehow, someway, we made it through episode number three of the option pricing crash course on extrinsic value. It's a lot to take in, so this is one of those times you may need to watch it a couple of times. You may need to slow some things down and take some notes to kind of add to your own personal study resources.

But when you are ready, I will see you inside of episode number four, where we are going to answer the question: Why do option prices move? I'll see you inside. Hey, Jim's back with you guys for the option pricing crash course.

We are now inside of episode number four, and we've already established a nice little foundation. We've looked at the option contract, we've studied intrinsic value, and we've also studied extrinsic value. So now it's time to begin to apply what we've learned by answering the question: Why do option prices move?

So let's dive in. At this point, my hope is that it's pretty clear to you that an option price can only change for one of two reasons, right? Either the intrinsic value changes, or the extrinsic value changes.

Those are the only two factors in an option's price. So a change to an option's price has to be related to one of those two. Just as we saw when we learned about intrinsic value back in episode number two, it's actually really simple and really, really straightforward.

If an option is in the money, it has intrinsic value; if an option is not in the money, it does not have intrinsic value. So when we're talking about an option price changing due to a change in intrinsic value, we're really talking about one of two things: either an option that was out of the money is now in the money—so where it used to have zero intrinsic value, it now has some intrinsic value—that would certainly change an option's price; or an option that was in the money is now deeper in the money, or not as deep in the money, or possibly even out of the money. If it has moved deeper in the money, its intrinsic value will increase, so its option price will increase.

If it's not as deep in the money, its intrinsic value will decrease, so its option price will decrease. And if it's now out of the money from having been in the money, it will have lost all of its intrinsic value, so its option price will decrease even more. Alright, fairly straightforward!

But what about extrinsic value? Well, just as we learned about in episode number three, the previous episode, this is going to be a little bit more involved. So on one level, the things that are impacting extrinsic value can be boiled down to one of three things: time, volatility, and proximity effect.

But if we go even a bit deeper—into a deeper level—now we want to start to figure out, okay, what is impacting these three things specifically: time, volatility, proximity effect? Because if we can uncover that, then we can learn a lot about what's going to cause extrinsic value to change and thus cause an option's price to change. So let's start with a closer look at time.

We know that more time means more extrinsic value and less time means less extrinsic value. We saw that back in episode number three. But if we take this a bit further and begin to apply it strategically, here's what that looks like: If I'm selling out-of-the-money options, then I know that 100% of the option price will be extrinsic value.

I know this because out-of-the-money options don't have any intrinsic value, so the only component of the option price is extrinsic value. Therefore, if I choose to sell an option with more time, then I'm going to be able to collect a greater credit, and as a result, I'll have a wider break-even point and higher profit potential. Of course, I will have to potentially hold the option for a longer period of time, though.

But if I were to choose to sell an option with less time, yes, I won't have to hold it as long, but the lower credit I will collect will leave me with a tighter break-even point and lower profit potential. Now, at Tasty Live, we feel that the 45 days-to-go marker is a really good hybrid between duration and credit collected at trade entry, but more on that in the final episode of this option pricing crash course. So now let's take a closer look at volatility and how it moves option prices.

More volatility means more extrinsic value; less volatility means less extrinsic value. As we've already seen, again, if we're focused on out-of-the-money options, we're only dealing with extrinsic value in the option price. So what causes volatility to expand or contract?

Of course, volatility itself is a random entity in the market, just like everything else. But if we focus on expansion, there are two events that often lead to significant increases in volatility: market drops and binary events. Market volatility and market.

. . Prices are inversely related most of the time, so if the market suddenly drops a sizable amount, there is a good chance that volatility will have expanded rapidly.

One way to intuitively understand this is that the market usually rises over time, so a large drop can obviously spook a lot of investors, leaving them feeling a lot more uncertain about the future. As a result, market volatility rises to reflect that added uncertainty in regard to binary events such as a Federal Reserve announcement or a company earnings report. The possibility of large moves as a result of these events is higher than it would be for just any old normal day.

Therefore, to reflect this increased possibility of a big move, volatility will often rise leading into these events. On the contraction side, given the inverse relationship between market price and market volatility that we just mentioned, and a market that wants to grind higher over time, what you end up with is market volatility usually in a state of contraction. In fact, according to Figure 2.

2 inside *The Unlucky Investor's Guide to Option Trading*, the market is either in a low state where volatility is slowly dropping or a contraction state where volatility quickly crashes, approximately 90% of the time. At Tasty Live, this is where we feel the most opportunity lies in the marketplace: selling options in stocks with high implied volatility to position ourselves to benefit from that volatility contraction. All right, so lastly, let's take a look at the proximity effect and figure out what might impact that and thus impact option prices.

This one doesn't necessarily have a clearly defined trigger like time or volatility did, but instead, if one of the limitless random forces of the market were to move a stock in a big way, either closer to or further away from its strike price, the options in that stock are going to be affected significantly. As we learned back in episode number three, if the stock moves further away from an out-of-the-money option, the proximity effect will be weaker, its extrinsic value will fall, and its option price will move down. If, however, the stock moves closer to an out-of-the-money option, the proximity effect will become stronger, its extrinsic value will rise, and its option price will also rise.

Again, this is mostly what we saw back in episode number three, but it is so, so, so important that it's worth mentioning again here. Now, here are some of the factors that move option prices, and my hope is that by taking the time to understand these things now, you’ll be better equipped to recognize them when they’re happening to you with your positions inside your portfolio in the live market. All right, we are almost done—one episode to go before I cut you loose and let you go into the forest.

I bet right now you are wondering, "All right, Jim, this is good stuff. This is important stuff to understand, but how do I put all this together and take advantage of everything that I've learned? " You know, that is such a great question that I've decided to make its answer the entire subject matter of episode number five.

So I'll see you inside. Hey, Jim Schz, back with you guys for the final episode of the option pricing crash course—episode number five: Taking Advantage of Option Pricing. Now, if you've made it through episodes one through four, then you have all the tools necessary in your toolbox to begin to take advantage of all the things that we have learned.

Now, to be clear, there are still so many things that need to be considered beyond option pricing, with strategy selection and portfolio management and all kinds of stuff. But using just what we've learned in this crash course alone—the first four episodes and then this episode—you might be surprised at what you'll be able to apply to the marketplace. All right, so let's do it.

Let's dive right into episode number five, the final episode of the option pricing crash course. So to kick things off here in this final episode, let's shoot from strength. Let's identify something that you may have already noticed: There are really only three ways that you can make money from options.

Yes, interest rates and dividends factor into this equation too, but the interest rate impact is often negligible, and not all stocks pay dividends. So keeping our focus on the three main drivers makes the most sense. You can make money through direction, time, and volatility, which is interesting because the three factors that impact option pricing the most are the proximity effect (which is basically direction), time (which is of course time), and volatility.

The three option Greeks that will play the biggest roles in your positions without a doubt are Delta (which is direction), Theta (which is time), and Vega (which is volatility). So hopefully you can see the connection and parallel between option pricing P&L and the overlapping factors that contribute to both. Man, I mean, it's almost like all this stuff is connected mathematically and quantitatively.

So, okay, got it. We make money by Delta, Theta, and Vega. Well, let's take this idea one step further by actually going a few steps back to the option contract itself.

Remember, at trade entry, you decide which side of the contract you want to be on. You could be on the long side; you could be on the short side. Well, given that choice, take a look at this: If you choose to buy the option and take the long side, it's important to recognize that you can only make money in two of the three possible ways—direction and volatility.

You can get the directional move right, or you can benefit from volatility expansion, both scenarios leading to higher option prices, which is what you want. But time will always be working against you. You will never be able to turn Theta into a positive for your P&L; that is the price you pay for unlimited profit potential.

Conversely, if you choose to sell an option, take the short side. You can make money in all three of the possible ways: direction, volatility, and time. A directional move in your favor will help you, a volatility contraction will help you, and the simple passage of time will also help you.

All three profit drivers are a form of compensation for having to bear the added risk of unlimited risk. And hey, I can't speak for you, but first, it's really hard to predict market direction correctly and consistently, and second, having the passage of time—which is pretty much as close to a sure thing as we'll ever get—working for you is an incredible advantage. So, my conclusion: selling the option, taking the short side of the contract, is the clear winner in my view.

Building on those incredible advantages from positive Theta and the simple P&L of time and what they give us as the option seller, let's go one step further and talk about where we like to enter our trades and where we like to exit our trades. If we look more closely at the extrinsic value decay curve for an out-of-the-money option, specifically, we see a couple of important points. First, we like to enter our positions around 45 days to expiration, as we talked about in the previous episodes.

Well, if you look at this out-of-the-money decay curve right around that 45-day mark, you will see the slope of the decay curve begin to change in such a way that the decay is accelerating. That's exactly what we want! But second, we also like to exit or adjust our naked positions at 21 days to expiration.

Well, notice what happens to decay just shortly beyond that point: it slows down dramatically. So, in other words, if we continue to hold an out-of-the-money position closer and closer to expiration, we are not being compensated with the same rate of extrinsic value decay that we had in the first half of the expiration cycle. Therefore, we prefer to get out of the trade, or at least out of this expiration cycle, at this time.

Isn't that incredible? I mean, if you've not seen that before, that is a real eye-opener! But here's where it gets a little crazy: that's actually not as surprising as this final point.

This is another direct quote taken from the "Unlucky Investor's Guide to Options Trading": historical data shows that perceived uncertainty in the market, implied volatility, tends to overstate the realized underlying price move more often than theory suggests. So, in other words, IV might be pricing in a $12 move, but on average, that move is only $10. Or, IV might be pricing in a $25 move, but on average, that move is only $15, and so on.

So, very similar to the foundation that Anton helped us with in an earlier episode, this gives the option seller an incredible advantage. Option prices are determined by implied volatility, but as we've seen empirically, implied volatility frequently overstates the amount of extrinsic value that should be in the option. So we are being overly compensated for selling that option and bearing all of that unlimited risk.

But very simply, the actual moves in the marketplace end up being, on average, less than the expected moves that were priced into the marketplace based on that implied volatility. Again, lots to consider from here, lots of additional decisions to make and questions to answer. But do you think that you could take advantage of that?

I certainly do! So, I really appreciate you guys. Man, I appreciate you guys so much.

I am humbled that you stayed with me all the way through this crash course. I really hope that you got some value from all five episodes in uniquely different ways. If I can ever help you guys in any way, please do not hesitate to reach out.

You can email me at jschultz@tasty. com, or we can connect on Twitter or X—or whatever they're calling it these days—@jschultzF3. I would love to hear from you and help in any way that I can.

So, that's it! The option pricing crash course has come to a close. I will see you guys next time.