Basics Of Options
After we have learned the six factors that affect Option Premium, let us understand how options pricing is done.
How is pricing of Options done theoretically?
Option pricing theory uses different variables, which we discussed above (stock price, exercise price, volatility, interest rate, time to expiration), to theoretically derive the value of an option.
The primary goal of option pricing theory is to calculate the probability that an option will be exercised, or be in-the-money (ITM), at expiration. The most commonly used model to derive the fair value options is the Black-Scholes Model. The theory provides an estimation of an option's fair value which traders incorporate into their strategies to maximize profits.
In real life trading, options prices are determined in the open market and, the value can differ from the theoretical value. However, having the theoretical value allows traders to assess the likelihood of profiting from trading those options.
The Black Scholes model is perhaps the best-known options pricing method. So, let us discuss this particular model in the next unit.