In 1973, three men – Fischer Black, Myron Scholes and Bob Merton – presented a model (the Black-Scholes formula) for pricing an option. We covered the equation in the first installment of our “Options 101” series [earlier in the] week.

It was, and still is, considered one of the most important mathematical modeling tools of our time.

[ad#Google Adsense 336×280-IA]Why? If you can price an option, you are essentially pricing risk.

An option is a bet on the direction of an underlying asset (or stock). In order for that bet to make sense, it has to incorporate the risk of the asset moving up or down in price.

But there’s more to it than just direction. Several other important components come into play before an option’s price is determined.

The formula itself, which I showed you last [time], would require a really strong background in mathematics to decipher.

Today, I’m going to explain it in more understandable terms.

Each component (more on those below) is important in its own right. However, some components can affect price more than others. The following is a quick guide that covers the important stuff…

The first component is time.

Options are all about time.

The more time until an event (the option’s expiration date), the more expensive it will be. So an option that expires in one month will be a lot cheaper than one that expires in a year.

I usually prefer longer-dated options, as they become proxies for the underlying shares. But there are occasions where short-term, cheap options are appropriate.

Earnings announcements are a good example. If you think a company will report great or poor earnings, making a bet using an option is one way to play it.

The second component is the strike price.

This is the price at which you agree to buy or sell the underlying stock.

The further the strike price is from the market price of the stock, the lower the option price will be.

For example, let’s say stock XYZ is trading at $20. Buying a $22 strike price option will be much more expensive than buying a $30 strike price option with the same expiration date.

That’s because the probability of the stock going from $20 to $30 is much, much lower than the odds of the price going to just $22.

The higher the probability of the event occurring, the more expensive the option.

The third component is the risk-free rate of return.

This is the minimum rate of return an investor is willing to accept without taking any risk.

I usually calculate this using the rate of the 10-year Treasury bond. As the rate increases, investors should require greater returns from their non-risk-free investments.

Higher rates equate to higher prices for call options, and lower prices for put options. The inverse is also true.

The fourth and the most important component is volatility.

The more volatile a stock, the more expensive its options will be.

Think of it like this: A big, reliable blue chip stock like AT&T (NYSE: T) won’t have the same price as a (comparably) small biotech company like Valeant Pharmaceuticals (NYSE: VRX).

AT&T has a long history of stability and is not considered a high-growth stock. Valeant, however, is all volatility right now.

AT&T’s current implied volatility is around 12, while Valeant’s is around 80. This means Valeant shares are much more volatile than AT&T shares.

There are two types of volatility: implied and historical.

Implied is volatility based on current market prices and conditions. Historical refers to the price and volatility movement over a long period of time.

Both are important, and both should be used in trying to determine a fair option price.

Now, when you’re trading options, you’re not determining their prices yourself. The “market makers” do this.

But knowing what an option’s price should be versus what it’s actually trading for gives you an edge over other traders who take the option’s market price at face value.

Fortunately, there are a variety of free options-pricing calculators on the web.

They calculate the price based on the factors above and allow you to change your parameters like volatility or risk-free rate… Or you can use the ones they have precalculated.

Click here to check out a free, simple options-pricing calculator. And click here if you’re interested in looking up free implied volatility data for stocks.

You can bet the options market makers use a calculator!

Good investing,

Karim

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Source: Wealthy Retirement