by Ian Harvey
August 22, 2019
Options pricing can be tricky, and buying options at the going displayed price can sometimes leave you feeling that you were “ripped off,” as you managed to spend more than planned.
A similar situation which leaves you with a “ripped off” feeling is when you are purchasing a car. Even though you had meticulously done your research – such as checking the Kelley Blue Book or Edmunds as sources for determining a fair price for the car, checking the dealer cost, the add-ons, etc., - you walked away after purchasing the car to realise that you had paid more than you originally planned.
This happens because the dealer knows better – he isn’t dealing in retail….as he deals in wholesale. Therefore he uses the “black book,” which values your car at a substantially lower price.
What does this have to do with buying options and options pricing?
Let us come back to that question at the end of this article, as it is essential that you should first understand what is meant by options pricing.
Understanding Options Pricing…..
An option price is the sum of two components…..
Option value = IV + TV
IV is the difference between the stock price and the option's strike price. However, IV cannot be less than zero. IV is calculated based on how the underlying stock price moves in relation to the option strike price:
What is Option Pricing Theory?
Option pricing theory uses variables (stock price, exercise price, volatility, interest rate, time to expiration) to theoretically value an option. Essentially, it provides an estimation of an option's fair value which traders incorporate into their strategies to maximize profits.
Commonly Used Models to find Options Pricing…..
Of these, the Black-Scholes model is the most widely used. However, this model was developed mainly for European options pricing on stocks, and it cannot be applied to the American-style options due to their feature “to be exercised before the maturity date.”
Therefore this leads us to back to the question - What does this have to do with buying options and options pricing?
As mentioned about car dealers using a “black
book” to obtain the best price – the equivalent Black Book can be found for
options pricing... while everyone else is using the Blue Book.
Here's how to do that...
Pull up a stock quote for any company. Then click on the tab for options, which is usually on the same page as the stock quote.
You will pull up what is known as an "options chain," which shows all the puts, calls and pricing for that stock. Click on an option.
Note: This exercise works best with a relatively well-known company that has some trading volume. You can figure out the trading volume by looking at the number in the "Open Interest" column. That reflects how many options contracts are still outstanding or owned (or shorted) by individuals or institutions.
Now look at the bid and offer price. If you want to sell an option, you will use the bid price as a guide or sell somewhere between the bid and offer. If you want to buy, you would use the offer price.
Now click on this link. You'll see a group of columns. Each one asks you for an input number. It looks like this:
All the numbers are readily available from
your stock or options quote.
Use "3" for the interest rate (risk-free rate of return) to reflect the 3% yield on 10-year Treasurys. The number for volatility is usually found under the heading "Volatility," "Implied Volatility" or "Beta" in your quote.
Don't worry about rounding or graph increments. Put the numbers in and it will display what the put or call option is worth.
Compare the two and that's where you'll find out whether you're getting the "dealer price" (the wholesale price) or the "customer price" (the retail price).
By being able to obtain the correct options pricing you are now in a position that allows you to increase your odds in the market place.