How Do You Get The Best Price

When Buying Options?

*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…..

**intrinsic value**(IV) and**time value**(TV),

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…..*

- Black-Scholes,
- Binomial option pricing, and
- Monte-Carlo Simulation.

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).

*In
Summary…..*

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.

Ian Harvey

Director of Stock Options Made Easy

Options traders are not successful because they win.

Options traders win because they are successful.