Option Investor
Educational Article

Not All Options Are Created Equal

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Were moving right along, gang. Last week we learned which options are in-the-money, at-the-money and out-of-the-money. Today were 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 wasnt e=mc2. Einstein already cornered that market, but its 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 didnt 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 its under priced, it may be a bargain. If its 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

Dont freak out. Youre not back in a calculus class here. I wouldnt put you through that. Hell, if I have count past ten, I have to take off my shoes. Youre 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 were 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 traders 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 youre 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 weeks 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 youre overpaying or underpaying. Options are no different.

Youve probably noticed some of the other headings on the chart above. Those are knows as the Greeks. Well get into those a few lessons down the road. Theyre good to know, though some are more important than others.

Answers To Last Weeks 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 youre serious about learning options. The Pulitzer people wont likely be knocking at my door any time soon, but Ive taught a lot of people how to conservatively and consistently make money and theyre still making money to this day. I hope youll become one of them. See the links at the end of this column and have a ball.

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This Is Good Stuff
Just a reminder that, if youre new to options, these basic articles are valuable. Print these articles out so you can reference them at your leisure. This is your bible for the options basics. Its information you need to know before you risk your hard earned dead presidents and it may very well become a collectors item. What better reasons can there be?

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Mike Parnos - A Little Knowledge Goes A Long Way
The outspoken Mike Parnos has been writing Option Investors very successful Couch Potato Trader column for over four years. Hes been trading and teaching options for over 15 years and knows what you NEED to know to trade options profitably.

Too many traders trade the more advanced option strategies without having a good understanding of options, how they work, and how they are meant to be used. The results? Say goodbye to your money. That is why there such a stigma attached to options. And thats a recipe for disaster. If you have more money than you know what to do with, losing $5,000 or $10,000 is no big deal.

However, if youve worked hard for your money, and you appreciate the value of a dollar, you should make every effort to learn everything you can about options before you put your money at risk.

Mike tells you like it IS, not how you hope it will be. As you read through the columns, feel free to send him your questions at support@optioninvestor.com.

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