This article explores how options are priced, helping traders to understand past the “basics.” At the end of this article, you should be able to understand options pricing and have a better chance of recognizing when options may be mispriced in your favor and when they are not. Thus, giving you the tools set to potentially identify the next Gamestop option play.
Without any further ado, let’s get straight into understanding how options are priced!
Basics of Options Pricing
Options are a contract type between two parties, with one party having the right to sell an underlying asset and the other the right to buy either at a predetermined price or before the expiration day.Options are of two types: puts and calls. While call gives the right to buy an underlying asset but offers the right to sell the underlying asset. Note that these contracts only provide both parties the right and not the obligation.
There are various options pricing models; in this article, we will only analyze the Black-Scholes Model as it is the most typical pricing model employed by options traders.
The Black-Scholes Model
Coined in 1973 by Fischer Black and Myron Scholes, the Black-Scholes Model was developed primarily to price European options on the stock. This model is based on various assumptions about stock price distribution and the economic environment.The Black-Scholes Pricing Formula
C = Call option price
S = Current stock (or other underlying) price
K = Strike price
r = Risk-free interest rate
t = Time to maturity
N = A normal distribution
δ = Dividend yield
σ = Volatility
Understanding The Stock Option Formula
The formulas posted above are definitely not easy to understand, however, in the rest of the article, we will attempt to give a much easier understanding of how options are priced covering the most important coefficients of pricing: Delta, Gamma, Theta, and Implied Volatility. This hopefully will give you an increased knowledge of options pricing which will give you better insight into what a good and bad option trade will be.
Delta is how much your options appreciate/depreciate, as the underlying price of the stock moves. Out-of-the-money options have the lowest delta since it's so far out of the money. In-the-money options have the highest delta.
A good example of the impact Delta has on your stock option pricing is as follows, say your stock moves $10, and the delta is .5, it basically means you should expect roughly $5 to be added to your option value.
When you are buying deep-in-the-money options you are really paying a lot for delta.
Note the following about Delta:
- Delta increases near expiration as well as when the option prices become closer to at-the-money.
- Gamma is used to calculate new values of Delta. So Delta will not always be constant.
Gamma
This is Delta's rate of change with time. As such Delta will not always be constant it will be a factor of Gamma. Basically, as the price moves towards a certain direction, Delta will be recalculated using Gamma. This is likely the least interesting aspect of option pricing.
Note the following about Gamma:
- Gamma is highest for near-the-money options.
- Gamma is the smallest for out-of-the-money options.
- Gamma is negative for short options and positive for long options.
Theta
Theta measures the time it takes for an option’s value to erode. The profitability or in-the-money probabilities of an option reduce with time. So as time passes and the price does not move, theta diminishes. Obviously, this is exactly what sellers want. Note when you pay for out-of-the-money options, you are really paying a lot for the Theta.
Note the following about Theta:
- Theta is negative for single options and long options.
- Theta is great for sellers but bad for buyers.
- Out-of-the-money options with a lot of implied volatility have high Theta value.
- Theta is also high for at-the-money options.
Implied Volatility
Implied Volatility is where the money is at, if you find a stock with mispriced volatility, that is where you will make the millions. In short, if the implied volatility is NOT priced properly based on an upcoming catalyst, that is where the exploitation will occur. This is what Roaring Kitty identified was mispriced when it came to Gamestop's out-of-the-money options. Now let's explain what exactly Implied Volatility is.
Implied Volatility (IV) will determine a trade's potential, setting the current price for an existing option. It's a measure of future volatility. In other words, if your stock has moved a lot recently expect the IV to be quite high, or if earnings are about to be released or a meaningful catalyst is about to occur.
This is why sometimes you see an option price looking more expensive than usual, it's the implied volatility!.
The way millions were made trading GameStop, was the IV did not price in console launches, hence many savvy traders discovered the options were severely mispriced. As a result, many went deep into buying out-of-the-money options and eventually made millions as their options appreciated exponentially.
Note the following about Implied Volatility:
Note the following about Implied Volatility:
- A stock that moves hard and fast in one direction will always have high Implied Volatility.
- Current Implied Volatility does not mean future Implied Volatility will not collapse. Therefore be careful buying when the IV is high!
- The best way to make money in options is to exploit mispriced IV. Where a proper future event has not been properly calculated when it comes to the company.
Conclusion
Having read this article, I hope you have considerable insights about how options are priced and can now make better and more informed decisions when trading options. Hopefully, with this new understanding, you may be able to find mispriced options and find the next GameStop!Should you have further questions, do not hesitate to ask via the comment section. Or please check out the dangers of trading out-of-the-money options or Why Options Trading Is Bad as well as How To Trade Stock Options Using Proven Strategies.