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The 6-Week Options Trading Kickstarter: Options Pricing Basics


Steve Smith breaks down the basics of options pricing.

Editor's note: To help investors profitably navigate the options market, Minyanville is launching "9 Weeks to Better Options Trading," an educational series aimed at increasing trader understanding of the nuts and bolts of options, with an emphasis on real-world applications. In this series, veteran options trader and author of OptionSmith (Click here for a two-week FREE trial and get Steve's best trading ideas in real time) Steve Smith will demystify a range of topics from options pricing to trading strategies to special situations like earnings reports and takeovers.

For the first article in the series, click here.

If you are a novice options trader, we suggest you start with Steve Smith's 6-Week Options Trading Kickstarter series.

One of the keys to successful options trading is judging whether an option is fairly priced. Unlike stocks, options have a theoretically unlimited supply, and thus an options market will never independently experience a short squeeze. And because the options are tied to stock prices, the value of the puts must be related to the calls or there would be risk-free arbitrage available. It is the market maker's job to keep the puts and calls in line. But this doesn't mean that prices can't vary widely within an individual issue over different time frames.

The most commonly used apparatus for valuing options is the Black-Scholes model, which considers five factors in calculating a particular option's theoretical fair value:

1. The price of the underlying security

2. The strike price of the option

3. The time, or expiration date of the option

4. Interest rates

5. Implied volatility (or IV)

The first four inputs are known variables. To get number five, we plug those four inputs into the Black-Scholes model. This would give us "theoretical" implied volatility, which helps us decide whether an option is cheap or expensive.
No positions in stocks mentioned.

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