The 6-Week Options Trading Kickstarter: Options Pricing Basics
Steve Smith breaks down the basics of options pricing.
Editor's note: To help investors get their feet wet with options trading, Minyanville has launched this "6-Week Options Kickstarter," an educational series aimed at increasing understanding of the basic nuts and bolts of options. In this series, veteran options trader Steve Smith will take you through options fundamentals with an emphasis on real-world applications. Note: Intermediate or advanced-level traders may get more mileage out of Minyanville's 9 Weeks to Better Options Trading 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.
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