We’re moving right along, gang. Last week we learned which options are in-the-money, at-the-money and out-of-the-money. Today we’re going to learn what makes up the price of an option.  Once upon a time, long long ago (1973), there were two guys – Fischer Black and Myron Scholes. They got together, had a few beers, a bag of Doritos, and somehow came up with a formula. No, it wasn’t e=mc2. Einstein already cornered that market, but it’s all relative. Fischer and Myron came up a complicated formula that is still used today in calculating the “fair value” of options. They probably also needed a bottle of TUMS to get through it, but they did. And damned if they didn’t win a Nobel Prize for it, too.

Do you need to know the formula? No, that would take up potentially useful grey matter. All you need to know is that there is a “fair value” for each option. When you look at the option chain and see the actual pricing of an option, you can compare it to the “fair value” and thereby determine of the option is over priced or under priced.

In pure shopping terms, if it’s under priced, it may be a bargain. If it’s overpriced it may not be worth considering and you may be better off waiting for it to go on sale.

What are the important components that go into the Black-Scholes formula to determine the fair value of an option?

1. Stock Price

2. Strike Price

3. Time remaining to expiration

4. Current risk free interest rate

5. Volatility

Don’t freak out. You’re not back in a calculus class here. I wouldn’t put you through that. Heck, if I have count past ten, I have to take off my shoes. You’re not going to have to calculate anything. Any decent brokerage firm will have the “fair value” of an option available on their website.

Look at the option chain below (courtesy of BrokersXpress.com). This is a page full of a lot of good stuff. Right now we’re just going to focus on the yellow highlighted areas, more specifically – Theoretical Value. Based on the Black-Scholes formula, these are the “fair value” prices for the respective options at this point in time.

This is a chart of Amgen (AMGN) calls. Notice the $70 call (pink highlights). The bid price is $.45 and the ask price is $.55. The theoretical value is $.515. The fair value ($.515) is between the bid and ask prices. Therefore, you can assume the option is fairly priced. If the theoretical value was $.625, it would be higher and out of the $.45 – $.55 range. Because the option is trading below the range, it would be considered under priced. That would make it a bargain is some trader’s eyes.

By the same token, if the theoretical value was $.415, it would be trading below the $.45 – $.55 range. That would mean the option is over priced – no bargain.

Now, whether or not an option is appealing depends if you are an option “buyer” or an option “seller.” If you are buying options, obviously the lower the price the better. However, if you’re selling options, you would prefer it to be higher priced so you can receive more on the sale.

The theoretical value of the options you are considering is an important consideration in deciding which option TO trade and which option NOT to trade. Here are a few practice questions using the chart above.

The $67.50 call:

1. If the theoretical value was $1.585, the option would be consider a) overvalued, b) undervalued, c) fairly valued

2. If the theoretical value was $1.415, the option would be consider a) overvalued, b) undervalued, c) fairly valued

3. If the theoretical value was $1.37, the option would be consider a) overvalued, b) undervalued, c) fairly valued

The $65.00 call:

1. If the theoretical value was $3.185, the option would be consider a) overvalued, b) undervalued, c) fairly valued

2. If the theoretical value was $2.95, the option would be consider a) overvalued, b) undervalued, c) fairly valued

3. If the theoretical value was $3.025, the option would be consider a) overvalued, b) undervalued, c) fairly valued

The answers to the above questions will be in next week’s column. The concept of “fair value” is not tough to grasp, but is important to understand for trading some strategies. When you go shopping at the supermarket, before you buy, you want to know if you’re overpaying or underpaying. Options are no different.

You’ve probably noticed some of the other headings on the chart above. Those are known as the “Greeks.” We’ll get into those a few lessons down the road. They’re good to know, though some are more important than others.

Answers To Last Week’s Questions

Stock XYZ is trading at $53.75.

The $55.00 call is OTM by $1.25

The $50.00 put is OTM by $3.75

The $60.00 put is ITM by $6.25

The $45.00 put is OTM by $8.75

The $60.00 call is OTM by $6.25

The $55.00 put is ITM by $1.25

Missed Any Columns?

Hey, this is good stuff – especially if you’re serious about learning options. The Pulitzer people won’t likely be knocking at my door soon, but I’ve taught a lot of people how to conservatively and consistently make money – and they’re still making money to this day. I hope you’ll become one of them.

So, if you missed any of my previous columns, click on the following link and, hopefully, they will magically appear. www.tradingacademy.com/newsletters.htm .

Who Is This Guy? –

Mike Parnos has “been there and done that” – plenty! Known as “Online Trading Academy’s Options Therapist,” Mike has been trading, consulting and teaching option strategies for over 12 years. Both individually, and through his writings, Mike specializes in teaching conservative and non-directional option strategies while providing therapeutic guidance to thousands of individuals, brokers and institutional traders. Over the years, he has learned from his mistakes, and the mistakes of others, and he’s here to share his wisdom with you. “Trading is as much psychological as it is skill,” says Mike. “Keep an open mind. You never know what might find its way in there.”