How much Should I Pay for an Option?

Submitted by Stock Market News on 3 June, 2011 - 21:16

How to determine the fair value of an option.

Price is important in any transaction. It will determine if you have made enough money or exited at a loss. So it's important that you that find out if the price of the option is fair or not. This is calculated through an option pricing model, which provides a theoretical value for an option based on the variables that affect its price. Some variables can be calculated but others are based on the trader's assumptions.

You can determine the current share price, exercise price, and expiry date precisely. However, interest rates, dividends and volatility can only be estimated. The most difficult these to ascertain is the volatility of the underlying stock. It relies heavily on the assumption of the trader, particularly how the stock price will behave in the stock market. You will never know if your estimate of the stock price movement is correct until the expiry date.

Historical Volatility

Traders can use a stock's previous price action to calculate the price. It is the stock's actual volatility measured of a period of time in the past. With this method, the trader assumes that future price action will be the same as it did in the past.

Implied Volatility

This is basically a forecast of the stock's volatility during the life of the option. You assume the volatility of the stock by using the current market price of the option.
Using both of these assumptions you can determine whether the option is undervalued or overvalued. This may lead you to compare historical and implied volatility, or your own forecast over the option's life. If you think that the option is undervalued bought options may be more suitable. If it's the opposite written options may fare better.

ASX Option Calculator

If you want a convenient way of calculating an option's price you can use this calculator available in the ASX website. Default values including ASX estimates and volatility are inserted automatically by the calculator. A trader can also insert his own values to see how this may affect the theoretical value. You can also use a strategy modelling tool.

Determining an option's price proves how unpredictable the market can be. But with enough research and experience, you will eventually develop a gut feeling that will provide better assumptions in your future trades.