13 Minute Read

Options Theory: The Whiz-Bang Option Pricing Machine

September 10, 2017

By | 2 Comments

Options Theory: The Whiz-Bang Option Pricing Machine

If you’re going to befriend options and attempt to tap-in to their profit giving ways, you must of necessity learn their quirks. How do they behave and, perhaps more importantly, why do they act so? This will be the topic of today’s missive.

Options are instruments, yes, but they are also organisms. Living, breathing things that change over time. But unlike, say, a teenager that behaves unpredictably, options operate in a consistent, predictable manner. And thank goodness for that! Can you imagine trading a product that didn’t act as expected? One whose behavior was as fickle as the weather?

But no, option contracts operate as designed all the time, every time. It simply requires an understanding of their innards. In a moment we’ll commence with the dissection.

Options were the brainchild of three mathematical geniuses: Fisher Black, Myron Scholes, and Robert Merton. They had in their minds the idea of creating a perfect product, a derivative that could be used for hedging and speculation. One that allowed for a more sophisticated game of investing involving considerably less risk.

For days they toiled in their laboratory, testing and trying. But eventually their financial Frankenstein came fully alive. A peek into his anatomy would reveal six parts and six parts only: stock price, strike price, time to expiration, volatility, dividends, and interest rates. A change in any one of these variables is what drives the behavior of Franky.

If you want to be a top rate options aficionado I suggest you memorize all six. They are the inputs to what eventually became known as the Black-Scholes Model. If the Frankenstein metaphor is too messy, or if all this talk of anatomy and dissection conjures up stinky images of biology class and frogs, then allow me to switch metaphors.

The Black Scholes Model is a machine designed to create an option’s premium (aka an option’s cost or an option’s price). You put the six inputs into the machine and out pops an option’s premium. And since there are two option types – call and put – the machine is built to create a price for either one. Just switch the lever.

Math lovers may want to crack open the machine to see how exactly the Black-Scholes model ticks, but really, that’s unnecessary. You don’t need to know the complex formulas to trade options successfully. A basic understanding of how a change in the inputs impacts the output will suffice. Before we get to that, let’s change the graphic and state the inputs and output in terms we will use moving forward.

I’ve color coded each input and since the output is a combination of all of them, it includes every color. Like a rainbow!

Now, let’s look at how a change in each input modifies the premium amount. Remember that call options give you the right to buy a stock and put options give you the right to sell a stock.

Stock Price

The higher the stock price, the higher the option premium. A call/put on a $500 stock is more expensive than one on a $50 stock.

As the stock rises, calls get more expensive while puts get cheaper.

As the stock falls, calls get cheaper while puts get more expensive.

Strike Price

This variable is fixed and does not change over the life of an option. It is the price at which the option owner has the right to buy/sell the underlying stock.

The lower the strike price the more expensive the call and the cheaper the put.

The higher the strike price the more expensive the put and the cheaper the call.

Time

The more time to expiration, the more expensive the call/put

The less time to expiration, the less expensive the call/put

As time passes, all options lose value. This is a phenomenon known as time decay.

Volatility

Think of this as how much the stock is expected to move between now and expiration.

The higher the volatility, the more expensive the call/put

The lower the volatility, the less expensive the call/put

Dividends

When a stock pays a dividend (this is a distribution of profits to shareholders) its share price typically falls by the amount of the dividend. To be efficient, the Black-Scholes Model takes this into account.

Since a dividend payment reduces the forward price of a stock, it lowers call premiums while raising put premiums.

High dividend paying stocks have cheaper call options and more expensive put options.

Interest Rates

The impact of interest rates is minimal so I’m going to keep this explanation short and sweet.

The higher the interest rate, the more expensive the call and the cheaper the put.

The lower the interest rate, the more expensive the put and the cheaper the call.

If you really want to sink your teeth into option pricing, I suggest two things:

First, become a pro member of Tackle so you can get free access to the Options 101 video series. If you’re already a pro member you’ll find the class under the Learning Center. It includes hours of instruction on what makes options tick.

Second, play around with an option pricing calculator to experiment with how changing the different inputs impacts an options premium.


Tackle Trading: Financial Freedom is a Journey. Sign up now for a 15-day free trial.

Financial freedom is a journey

The Options Theory series is brought to you by Tackle Trading.

Sign up now and gain unfettered access to all of the quality content and powerful Scouting Reports that our Pro Members enjoy for 15-days absolutely free with no strings attached and let us show you what your trading has been missing.

Sign up now for a 15-DAY FREE TRIAL #


Legal Disclaimer

Tackle Trading LLC (“Tackle Trading”) is providing this website and any related materials, including newsletters, blog posts, videos, social media postings and any other communications (collectively, the “Materials”) on an “as-is” basis. This means that although Tackle Trading strives to make the information accurate, thorough and current, neither Tackle Trading nor the author(s) of the Materials or the moderators guarantee or warrant the Materials or accept liability for any damage, loss or expense arising from the use of the Materials, whether based in tort, contract, or otherwise. Tackle Trading is providing the Materials for educational purposes only. We are not providing legal, accounting, or financial advisory services, and this is not a solicitation or recommendation to buy or sell any stocks, options, or other financial instruments or investments. Examples that address specific assets, stocks, options or other financial instrument transactions are for illustrative purposes only and are not intended to represent specific trades or transactions that we have conducted. In fact, for the purpose of illustration, we may use examples that are different from or contrary to transactions we have conducted or positions we hold. Furthermore, this website and any information or training herein are not intended as a solicitation for any future relationship, business or otherwise, between the users and the moderators. No express or implied warranties are being made with respect to these services and products. By using the Materials, each user agrees to indemnify and hold Tackle Trading harmless from all losses, expenses and costs, including reasonable attorneys’ fees, arising out of or resulting from user’s use of the Materials. In no event shall Tackle Trading or the author(s) or moderators be liable for any direct, special, consequential or incidental damages arising out of or related to the Materials. If this limitation on damages is not enforceable in some states, the total amount of Tackle Trading’s liability to the user or others shall not exceed the amount paid by the user for such Materials.

All investing and trading in the securities market involves a high degree of risk. Any decisions to place trades in the financial markets, including trading in stocks, options or other financial instruments, is a personal decision that should only be made after conducting thorough independent research, including a personal risk and financial assessment, and prior consultation with the user’s investment, legal, tax and accounting advisers, to determine whether such trading or investment is appropriate for that user.

2 Replies to “Options Theory: The Whiz-Bang Option Pricing Machine”

  1. Avatar ESTEBANROA says:

    Useful Info to understand the options pricing..

  2. Rosemarykioko Rosemarykioko says:

    Great explanation of option pricing Tyler. I must admit I did geek out on the Black-Scholes model for two seconds when Matt introduced options to me 🙂

Comments are closed.

Chart Modal

Tackle Trading