Active trader Charlie Ferguson developed and uses an indicator, the IV burn rate, that might prove particularly useful to our subscribers. Because Ferguson writes with clarity, I thought it best to let Ferguson do the explaining in this Q&A format, starting with an explanation of what he trades.

My primary strategy involves scaling into a position of short vertical spreads on the weekly cycle; however, there are several trading methods that can gain from the concept of IV burn rate. It was my interest in capturing the accelerated IV decay in a weekly trade that brought this idea to light. It was clear that the closer expiration was, the less adequate the common pricing models became.

Further questions addressed the indicator, the IV burn rate.

1. What is the IV burn rate and how is it calculated?

Option premiums are the sum of two components, intrinsic and extrinsic value. The intrinsic value is straight forward. It is equal to how deep ITM (in the money) the strike of the option is. The extrinsic value is not nearly as concrete. There are a few complicated formulas floating around used to assign a value to this part of the option premium, but it's a best guess, at best. Extrinsic value is often incorrectly referred to as "time premium." Although it tends to disappear over time, it is not a result of time left.

The extrinsic value is solely determined by the market. It is the value assigned by "supply and demand." Often in the last week of the cycle, one can observe that the intraday value of an OTM option (all extrinsic value) will behave quite erratically relative to underlying price, historic volatility, the progression of time, and the other options in the chain. The extrinsic premium which is dictated by supply and demand is a known, in a current time frame, and is only valid as an input into the pricing model to produce a result for the unknown "implied" volatility. Given that it is impossible to predict the IV at some point in the future, pricing models lose their predictive capabilities in short time frames.

The extrinsic value will become zero at expiration, as does the IV; therefore, there exists a direct relationship between the two. Since IV will drive the intraday value of theta (best guess of IV decay over time), I elected to call the ratio of theta/extrinsic value the IV burn rate.

IV burn rate (percent) = Theta of the option/the extrinsic value of the option x 100

Note from Linda: As most options traders understand, the theta of long options is always negative and that of sold options is positive. This reflects the reality that the extrinsic value in long options decays, hurting the long option holder, while the options trader who has sold options benefits from such decay. Ferguson confirmed that he uses the absolute value of the theta, without plus or minus sign, when he's looking at individual options.

For example, Ferguson writes, as of late morning on Thursday, September 29, 2011, the SPX 1195 Quarterly calls had a theta of -1.26 and an extrinsic value of 1.50, so Ferguson computes the IV burn rate percentage to be 1.26/1.50 x 100 = 84 percent.

2. How do you use this in choosing single options or complex options strategies?

The IV burn rate helps to predict the premium behavior of an individual option over a short time frame (24 hours).

3. Did you make unexpected discoveries when observing the IV burn rate?

Actually, it was the "unexpected discoveries" when observing individual option behavior that led me to consider the IV burn rate as a metric for strike choice.

4. What are some general observations you've gleaned about the differences in burn rates?

The obvious one is that it is a good gauge of the overnight IV decay of a strike. A less obvious but far more powerful observation is that the greater the IV burn rate, the less the premium of the strike will be affected by price movement of the underlying.

Ferguson provided a concrete example.

If I were selling a call spread with three days left in the cycle, and the choices for my short strike were a 1220 strike with a mark (mid-price) of $1.50 and IV BR 35 percent or a 1225 strike with a mark of $0.93 and an IV BR of 54 percent, I would avoid the 1220 even though the premium looked good. If the market were to make a quick five-point move up, the premium of the 1220 could easily move to $2.50 and then be reluctant to recover on a correction. On the same move, the 1225 with a 54 percent IV BR would likely rise to only about $1.20 and would recover fully or drop lower than the initial $0.93 on a correction.

Often the premiums of strikes with higher IV BR will appear to freeze through the middle of the day, even during large grinding intraday trends. Then, if the market has a minimal gap the following morning, one can count on a strike with a high IV BR to lose the IV BR percent of its value or sometimes more.

5. Is the IV burn rate available anywhere or is it possible to set up a spreadsheet automatically calculating it?

It is a simple calculation that I used to do in my head or on a calculator, but that is cumbersome when trying to compare several strikes. I have been fortunate that a couple of my trading peers have tailor made spreadsheets for strategies we trade and have included the IV burn rate on them.

I want to thank Ferguson for sharing his calculation as well as his thoughts about how it might be used. I personally look forward to watching this IV burn rate and comparing how various options perform under the kind of trading conditions we've found ourselves in these days. Notice that Ferguson mentioned that "if the market has a minimal gap the following morning"? That's an acknowledgement of the kind of huge gaps we've sometimes had. Perhaps those huge gaps render some of these observations less reliable, so always test for yourself.

As always, I suggest caution in employing a new technique that you haven't tested. Test it long enough to be sure that it meets your trading parameters and that you thoroughly understand how it works under different market conditions. Those of you proficient in setting up spreadsheets to import streaming data can compare IV burn rates for options you might choose for various strategies. Those of you less proficient can do what Ferguson did in the beginning: do it manually. That's not always a bad tactic. Remember when you were learning in school and sometimes had to write things over and over? Such tactile learning increases the chances that we'll remember what we've learned.

Of course, I have to provide the usual disclaimers, too. This is not a setup that I have tested. Nor has anyone else at Option Investor.