The 6-Week Options Trading Kickstarter: Options Pricing Basics

By Steve Smith  SEP 27, 2012 1:00 PM

Steve Smith breaks down the basics of options pricing.



For the first article in the series, click here.


One of the keys to successful options trading is judging whether an option is fairly priced. Unlike stocks, options have a theoretically unlimited supply, and thus an options market will never independently experience a short squeeze. And because the options are tied to stock prices, the value of the puts must be related to the calls or there would be risk-free arbitrage available. It is the market maker's job to keep the puts and calls in line. But this doesn’t mean that prices can’t vary widely within an individual issue over different time frames.

The most commonly used apparatus for valuing options is the Black-Scholes model, which considers five factors in calculating a particular option’s theoretical fair value:

1. The price of the underlying security

2. The strike price of the option

3. The time, or expiration date of the option

4. Interest rates

5. Implied volatility (or IV)

The first four inputs are known variables. To get number five, we plug those four inputs into the Black-Scholes model. This would give us “theoretical” implied volatility, which helps us decide whether an option is cheap or expensive. But given that options trade regularly, there is already an "actual" implied volatility assigned to each option based on its price, which is constantly updating in real-time. Therefore, our mission, should we choose to accept it, is to determine whether an option’s current price looks cheap or expensive based on its volatility level.
Let’s go over exactly what implied volatility is. Implied volatility is a measure of the probability of a certain percentage price move occurring within a given time frame. It is typically anchored to the underlying stock’s historical or realized volatility, which measures recent price action.
A notable exception would be biotechs since shares of these names can trade rather benignly for months on end, while the prospect of volatility-inducing events, like FDA rulings, keeps implied volatility at elevated levels. For example, the 30-day historical volatility (or HV) of  Dendreon (NASDAQ:DNDN) is 79% while the current implied volatility stands at 115%, suggesting that traders are pricing in the possibility of a substantial move. 

By comparison, JPMorgan (NYSE:JPM) has a 30-day HV of 41% while the current implied volatility is just 29%. This “discount” of IV below HV would indicate that expectations for a big stock move are settling down following the hooplah over the big trading loss.
Now let’s look at how understanding historical volatility can be used to counter the “options don’t work” argument put forth by naysayers who get frustrated when they make an options bet and are correct on the direction of the underlying, but don't make money. We'll use Fusion-io (NYSE:FIO) as an example.

Fusion IO, ahead of its April 24 earnings report, saw implied volatility climb up to 90%, which was well above the 52% rate at which the 30-day HV was running at this time. This was because the options market was pricing in the 10% price move that the shares had averaged over the past four earnings reports.  The stock responded to the earnings with a 7% decline to $26.20. Immediately following the report, IV declined to 55%, or right back to the HV.

This type of drop in implied volatility is quite common following an earnings report or any scheduled event that has market moving implications. In this case, the combination of the options having overpriced the expected move and the post-earnings premium crush means that the value of puts did not go up much despite the drop in stock price. For example, the May $25 puts only gained $0.20 to $1.80 on the day after the earnings report. 

An increase in implied volatility ahead of an event is simply the expression of a higher probability of a larger-than-usual price move within a given time frame. In this sense, an increase in implied volatility is an artificial expansion of time. In other words, what could happen over a long period of time is now being priced into a shorter period of time, and that makes sense ahead of a volatility-inducing earnings report. Understanding where IV stands relative to HV, and why it is at the current level is crucial to assessing current option prices, and anticipating future moves.

If a volatility-inducing event like an earnings report is anticipated, implied volatility will revert back to the mean after the event. But if there is unanticipated news like a surprise FDA ruling on a drug, IV will spike.

With Fusion set to report earnings on August 9, expect implied volatility to start to creep up in coming weeks -- and then expect it to drop back towards 50%, or close to historical volatility, immediately following the report.

One site that offers an option calculator and historical and implied volatility readings over various time periods is

Time Is Square, Man

There’s a basic math formula used in the Black-Scholes model that is a good starting point for understanding the rate of decline in an option’s value due to the passage of time (also known as time decay or theta). Basically, we use the square root of time to calculate and plot time decay. The math involved in the nitty-gritty of evaluating theta can be extremely complex, so focus on this: Time decay accelerates as expiration approaches, meaning that theta is defined on a slope.


Just as it isn’t necessary to know how to build an engine to drive a car, you don’t need to know all the math behind the pricing of an option.  But it certainly helps to understand the concepts that make them stop and go.  And with experience, they’ll safely take you where you want to go.


2. Options Pricing Basics
3. Meet the Greeks
4. How to use Options: Three Basic Principles
5. Covered Calls
6. Hedging, Portfolio Protection, and Avoiding Disaster

Twitter: @steve13smith

No positions in stocks mentioned.


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