The pricing of options is critical to successful trading and is the basis for many option strategies. By comparing the theoretical price of an option, to the one observed in market, a trader can find opportunities through arbitrage and also identify exit points.
Arbitrage is simply the mispricing of an asset and can be a profitable options strategy. For instance, no option contract should sell for less than the difference between the spot price and the strike price, if the option is in the money. A BHP call contract with the spot price $40, and the strike price at $30, should never sell for less than $10. This is a basic example, but understanding option pricing opens up many more arbitrage strategies.
The calculator uses the Black-Scholes formula for European options and the Barone-Adesi And Whaley pricing model for American options.
Understanding option pricing also identifies entry and exit points. Many beginner option traders get caught up with the hope of big, quick profits. Traders can be disappointed when they find a trade go their way, but the final price of a contract and profit end up being much smaller than expected. Being aware of option pricing, might reveal that the current price factors in a large implied volatility value for example. As volatility drives the option price, and can change quickly, this can help a trader decide whether or not a trade is worth entering prior to commiting any capital.
The components that influence the price of an option are detailed in this article. The calculator above uses the Barone-Adesi And Whaley pricing model, which is an extension of the famous Black-Scholes equation, used to calculate the price of American options. The formula was first published in 1987, and produces a quick and relatively accurate option price despite being an older model. Generally speaking, American options are more valuable than their equivalent European counterparts, due to the availability for early exercise.
The easiest way to derive Black-Scholes
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