Here are a few pricing models to adopt when attempting to determine the price of an option. You only need to grasp a few good models thoroughly, and then use an online calculator. Each segment will go over some of the basic models and how you can understand them.

The Black-Scholes Model

In 1973, as a computing option premium, Robert Merton, Myron Scholes, and Fischer Black developed the Black-Scholes pricing model. This model has become the most famous since that period. Indeed, two years after Black died in 1995, Merton and Scholes received a Nobel Prize in Economics. Nevertheless, Black was still remembered for his work, although he was not given the Nobel Prize because only living people are awarded the Nobel Prize.

The Black-Scholes formula applies only to European calls; both call and put, and in its estimation does not include paid dividends. Nevertheless, using the asset’s ex-dividend value can still be used.

The model assumes that when it expires, the option can only be exercised. So that’s why they’re considering only European solutions. In fact, apart from not including paid dividends, no fees are also taken into account in this process.

It also means the economy is productive and market movements are not reliable. Volatility and interest rates that are risk-free are stable and well known. Finally, the Black-Scholes model assumes normal distribution of returns.

This alternative takes only one volatile asset, such as a portfolio, and then a risk-free asset, such as cash, into account. There is no settlement option with this, but with this arrangement there is a way for someone to borrow money at a risk-free basis. With this model, you can buy any stock, even a fraction of it, without any hidden fees or expenses. The options are calculated at the moment with this decision, as well as the payout. With a short investment option, you can create a long stock investment.

The Black-Scholes model requires the following to measure the option value:

• Risk-free interest rate
• Implied volatility
• Timing (expressed as a percentage of the year)
• Strike price
• Current asset price

The mathematical formula is complicated. To use it, an average person can be scared. Fortunately, online calculators are available that can be used to measure the price using this pattern. In fact, trading platforms have analytical tools that can be used to determine the price.

This is a good way to get an investing estimate, but it’s not the only thing you’re going to rely on. It may lead you to subject yourself to some major risks due to market fluctuations, liquidity risks, and sudden changes and threats. There are also drastic fluctuations in prices, and most of the time money in the real world does not come with an unchanging interest. It’s a good way to get an idea of what you’re about to do, but you shouldn’t rely entirely on it at the same time.

The Cox-Rubinstein Binomial Option Pricing Model

Mark Edward Rubenstein, Stephen Ross, and Carrington Cox created a variant of the Black-Scholes pattern, the Cox-Ross-Rubenstein model. This model’s primary advantage is that it uses a lattice-based model and over time takes into account the price movement of the underlying asset. A lattice-based model calculates the option’s lifetime shifts in multiple variables. Consequently, the effect is a more accurate price choice. It looks like a tree, and the depletion of the stock is advancing in that direction.

Used for American options, this model. This implies that all are immune to risk so that returns are equal to risk-free interest rate.

The Cox-Ross-Rubenstein model therefore states that because the economy is perfectly efficient, arbitration is not feasible. The underlying asset’s price can never go up and down at the same time. At any given time, it can only go in one direction. During the life of the contract, different points in time can be defined. Because of that, a binomial tree can be formed.

It is usually calculated from the start of the option to the end of the option, and then back again. Once this is done, it is then measured along with adjustments in option rates along with the parameters of the increases in dividend prices. All this is collectively calculated and put into a theoretical model to help others understand where their money will go.

The greatest benefit to this is that it works on American stocks. One downside is that it also allows you to see precisely where a stock is at a particular point. You should take a look at this, and you’ll learn about where that stock will be in the future through its empirical properties. In this way, it is beneficial.

But the biggest limitation is that calculating takes forever. All at the same time you are analyzing a lot of numbers, and many of the older computers can’t do that. However, with the technological changes, algorithms should keep up with the rate of changing numbers. You should get an online calculator to see where a stock is going to be at a certain point in time. Like the Cox-Ross-Rubenstein model, online price calculators and trading site analytical tools can be used to know the price of the contract.

The Put/Call Parity

Hans Stoll introduced the put/call parity as a pricing concept in 1969. There is a relationship between the European call and place options with similar strike price and expiry date, according to his study.

This implies that there is a specific fixed option value for each call option value at a given strike price. The same applies to the values of the option. There is a matching call option value at a common strike price for a put option value. The relationship exists because a position is generated that is the same as the underlying asset when there is a mixture of alternatives for positioning and calling.

The returns for the underlying asset and right must be identical in order to avoid arbitration. If the opportunity arises, traders and investors who take advantage of arbitration will make a profit.

The parity put/call is used to check EU options pricing models. If the parity test is not satisfied with the result of the pricing model, it means that negotiation will take place and the model must be dismissed as a pricing strategy. There are several methods to measure the parity of the place / call.

Thankfully, certain trading platforms provide tools for analysis. Which offer simulation of the parity of the place/call. But you don’t have to memorize all the pricing models completely, of course. Just choose one that suits your situation, have a handy online pricing model calculator, and let the numbers move for you.

If you find that you’re more of a “fast-and-loose” stock market investor, rather than the type of person who meticulously acts only after weighing the pros and cons of each potential outcome, then there might be a chance that you do not even currently have an options trading exit strategy in place.   

Why is an Exit Strategy Important?  

Firstly, it’s important to understand that some of the biggest reasons why investors need an exit strategy are emotional in nature.  Factors such as greed, fear, and even the rush of the investment game itself are some of the circumstances that can take hold of an investor and cause him or her to make rash and otherwise inadvisable decisions with their money.  Due to the fast-paced and sometimes one-sided nature of options trading, it is one of the most susceptible areas of the stock market to an investor’s emotional wear-and-tear.  Additionally, another important reason why every investor should be considering an exit strategy is because of the fact that it helps with money management.  Again, being an expert at managing your money is another area where many options traders fail at the task at which they’re trying to accomplish.  These are two of the most important factors that you need to keep in mind when you’re developing your options strategy, especially because you may not even be realizing how these factors are currently influencing your options trading decisions, for better or for worse.  

Exit Strategies and Timing for Options Traders  

One of the reasons why options trading is unique is because it requires investors to think about how time in influencing the value of an investment.  Each option is going to mature and expire, and the reality is that time is going to cause the value of the option to deteriorate as the maturation date grows nearer and nearer.  It’s never a good idea to decide on a whim that it’s the right time to sell or purchase a new option.  Instead, consider setting time stamps for yourself along the life of the option that will indicate whether or not it’s time to sell.  If you set specific intervals along the life of the stock, you’ll be able to look at the option more objectively than otherwise might be possible.  Doing this and sticking to these guidelines for each option that you purchase, or sell will help you to become more emotionless and less logical in your trading patterns. 

Rolling an Option  

In addition to thinking about the constrains of time in the most objective way possible, another good tip for developing an options trading exit strategy is to partake in what’s known as “rolling out”.  If you were to do this, you would first decide to close your options that are currently open under a particular underlying asset.  Instead of being done after this, you would open new options within the same underlying asset, only with different terms than the ones that you previously sold.  Essentially what you are doing is moving your options to a new strike price, without losing out on the gains that you can make from selling entirely.  More specifically, this means moving your options so that they are either positioned vertically or horizontally.  If you ultimately decide that you’re going to move them vertically, this means that you’re going to renew your options within the same month under the same underlying stock.  If you ultimately decide that you’re going to move your options horizontally, this means that you’re going to renew them within a different month.  Of course, when you roll an option you also have the ability to partake in both types of this movement, buying some vertically and others horizontally.   

Rolling an Option before the Expiration Date  

It should be obvious to you by now that time is a unique indicator of worth for an option.  This being the case, the rolling option exit strategy attempts to use time decay to its advantage rather than to its detriment.  Broadly speaking and depending on the time that the specific option has until expiration, there are certain times and days that are more significant than others from the perspective of how much an option is worth.  The chart below should help to clarify this point:   

As you can see from the chart above, the option begins to lose its value more quickly as it heads towards day sixty, and then decays even more rapidly around day thirty.  When a person who is holding an option sees this deceleration, it might be within the parameters of his or her exit strategy to even go ahead and roll their option over before the expiration date has come to fruition.  This way, they are leaving themselves and their money open for a situation to occur where they can potentially earn back some of the money that they’ve already paid to hold the option.  You might be wondering whether or not there are times when an investor will decide that he or she is not going to use the rolling exit strategy, but it appears that this does not happen very often.  The idea behind avoiding rolling over an option is that the investor is for some reason under the impression that the stock is going to appreciate more prior to the expiration date.  Of course, there are some instances where this does in fact seem to be the outcome, but from a general perspective an option is going to lose value towards the end of its life, rather than see appreciation at the end of its tenure.

Options allow you to create strategies that simply are not possible when investing in stocks. There are two ways that you can do this, they are known as strangles and straddles. This is a more complex strategy than simply buying a long call option or a long put. But it’s not really that complicated, you just have to understand some basics on how to set them up in order to make a profit.  

The strategy that is used in this case is dependent on a large move by the stock. There are many situations where this might be appropriate. But mainly, this is something you will consider using when you are looking to profit from an earnings call.  

Earnings calls cause major price shifts in the big stocks. The price shift is largely determined by what the analyst’s “expectations” are for earnings, and so this is not always a rational process. If the company beats the analyst expectations when it comes to earnings per share, this creates a positive “surprise” that will usually send the stock soaring. The amount of “surprise” is given by the percentage difference between the actual value and the expected value. So, in this case, if you had bought a call option, you could make amazing levels of profit from the option by selling it in the next day or two, as long as the new higher price level is maintained. 

But the problem is, you have no idea beforehand whether the earnings are going to exceed or fail to meet the analyst expectations. The silly thing about this (from a common-sense perspective) is that even if the company is profitable, if they fail to meet analyst expectations, this results in massive disappointment. So, you might see share prices drop from a sell-off even if the company is profitable. This is “surprise” in a negative way. 

The impact of failing to meet expectations can be magnified if the company also has some bad news to share. A recent example was an earnings call from Netflix, where they revealed that over the past quarter, they had lost subscribers. This news hit Netflix stock hard, it dropped by a walloping $42. If you had purchased a put option, that could have meant a $4000 profit.  

The problem is that you don’t know ahead of time which way the stock is going to go. It’s one thing to look back and say well you could have had a put option and made $4k in a day, but often companies reveal information in earnings calls that have been under wraps. Nobody had any inkling that Netflix was going to be losing subscribers until the earnings call.  

Second, analyst expectations are somewhat arbitrary. Defining success or failure in terms of them is actually pretty silly, but that is the way things work right now. But the point is it’s really impossible to know whether or not these arbitrary expectations are met prior to the earnings call. It’s also impossible to gauge the level of reaction that is going to be seen from exceeding or failing to meet expectations. 

Since we don’t know which way the stock is going to move, it would seem that a good strategy to use is to buy a call and a put at the same time. That is precisely the idea behind a straddle and a strangle.  

That way, you profit no matter what happens, as long as the price on the market changes fairly strongly in one direction or another. When you set up a straddle or a strangle, there is a middle “red zone” that bounds the current share price over which you are going to lose money. But if the share price either goes above the boundaries of this zone or below it, you will make profits.  

If the stock shoots upward, this means that the put option is going to drop massively in value. So, it’s basically a write off for you. But if the stock makes a strong move, as they often do after positive earnings calls, you stand to make enough profits from the call option that was a part of your trade to more than make up for the loss of the put. The potential upside gain is in theory unlimited. Of course, in practice, share prices don’t rise without limit, but they might rise, $10, $20, or $40, and that could potentially earn profits of roughly $1,000-$4,000, more than covering any loss from the now worthless put option. 

The opposite situation applies as well. If the stock drops by a large amount, you make profits. Profits to the downside are capped because a stock price cannot decline below zero. That said, if the stock drops by a significant amount, you can still make hundreds to thousands of dollars per contract virtually overnight.  

Doing this requires some attention on your part. You are going to have to think ahead in order to implement this strategy and profit from it. Remember that you can use a straddle or strangle any time that you think the stock is going to make a major shift one way or the other. An example of a non-earning season situation, where this could be a useful strategy, would be a new product announcement. Think Apple. If Apple is having one of their big presentations, if the new phone that comes out disappoints the analysts, share prices are probably going to drop by a large amount. On the other hand, if it ends up surprising viewers with a lot of new features that make it the must-have phone again, this would send Apple stock soaring. The problem here is you really don’t know which way it’s going to go. There are going to be leaks and rumors but basing your trading decisions on that is probably not a good approach, often, the rumors are wrong. A strangle or straddle allows you to avoid that kind of situation and make money either way. 

The same events that might warrant buying a long call such as a GDP number or jobs report, for options on index funds, are also appropriate for strangles and straddles. 

What Is A Long Straddle? 

To set up a straddle, you buy a put option and a call option simultaneously (buy = take a long position). The maximum loss that you can incur is the sum of the cost to buy the call option plus the sum of the cost to buy the put option. This loss is incurred when you enter the trade.  

With a straddle, you buy a call option and a put option together. And they would be with the same strike price. By necessity, this means that one option is going to be in the money and one option is going to be out of the money. When approaching an earnings call, the prices can be kind of steep, because you want to price them close to the current share price. That way, it gives us some room to profit either way the stock price moves.  A maximum loss is only incurred if you hold the position to expiration. You can always choose to sell it early, if it looks like it’s not going to work out and take a loss that is less than the maximum.  

There is a total premium paid for entering into the position. This is the amount of cash paid for buying the call added to the money paid for buying the put. This is called the total premium. There are two breakeven points: 

• To the upside, the breakeven point is the strike price + total premium paid. 
• On the downside, the breakeven point is the strike price – total premium paid. 

It the price of the stock moves up past the breakeven point, the put is worthless. However, the call option would earn substantial profits. On the other hand, if the stock price moved down past the lower price point, that would be the breakeven, the call option would be worthless and the put option would earn substantial profits.  

For example, suppose that we buy a $207.5 straddle on Apple 7 days to expiration with an implied volatility of 35%, and the underlying price is $207. The total cost to enter the position is $8.03 ($803 total). At 1 day to expiration, the share price breaks up to $220 a share after the earnings call. The put expires worthless, but the call jumps to $12.50. The net profit is then $12.50 – $8.03 = $4.47, or $447 in total per contract.  

If instead, the share price had dropped to $190, the call expires worthless, and the put jumps to $17.50 per share. The net profit, in this case, is then $17.50 – $8.03 = $9.47 per share or a total of $947. 

This isn’t to say that the straddle would be more profitable for a stock decrease, it is not. The profit will be the same no matter which way the share price moves, in our examples, we used two different sized moves. The point is to illustrate that no matter which direction the stock moves, you can profit.  If the stock is at the money at expiration, we could still recoup some of the investment and sell the straddle for a loss. In this case, the call and the put would both be priced at $152. We’d still be at a loss, but we could recoup $304 by selling both at $152.  

Short Straddle 

If you sell a straddle, then you are taking the opposite position, which means you would be betting that the share price stays inside the range and hope that the stock didn’t make a big move to the upside or the downside. To sell a straddle you’d have to either be able to do a covered call and protected put or be a level 4 trader who could sell naked options. 

Long Strangle 

A strangle is similar to a straddle, but in this case, the strike prices are different. In this case, you will buy a just barely out of the money call option, while simultaneously buying a slightly out of the money put option. The two options will have the same expiration date. The breakeven points for a strangle are going to be calculated in a similar way as the breakeven prices for a straddle, but you are going to use the individual strike prices for the call and put because they are different. So, you calculate the total premium paid, which is the total amount paid for the call option plus the premium paid for the put option. Then the breakeven points are given by the following formulas: 

• To the upside, the breakeven point is the strike price of the call + total premium paid. 
• On the downside, the breakeven point is the strike price of the put – total premium paid. 

In a similar fashion as compared to a long straddle, the maximum loss is going to occur when the share price ends up in between the two strike prices. Therefore, you might want to choose strike prices that are relatively close, in order to minimize the range over which the loss can occur. Of course, there is a tradeoff here because the closer in range the strike prices are, the more expensive it is going to be in order to enter the position. But, it’s going to increase your probability of profit because if the strike prices are tight about the current share price, there is a higher probability that the share prices are going to exceed the call strike + premium paid, or decrease below the put strike price less the price paid to enter the contract the premium.

Assuming a Long Position 

When you buy stock, you get what is known as a long position. When you buy a call option you get into a potential long position based on the underlying stock. On the other hand, when you sell a stock short, then you are short selling.  

This essentially gives you a short position. Short selling means that you sell at a loss while long selling implies a profit. When you sell a naked call or an uncovered call, you will enter a potentially short position based on the underlying stock. 

Assuming a Short Position  

You enter a potential short position based on the underlying stock when you purchase a put option. Should you sell a naked put, you will enter a potential long position relative to the underlying stock.

If you can understand these four positions and keep them in mind, then you will easily understand the intricacies of selling and buying options. Ideally, you can buy call options and put options as well as sell call options and put options. 

Holders: Anyone who buys options is generally referred to as the holder of an option 

Writers: A person who sells an option is generally referred to as an options writer 

Call and put holders are also known as buyers. They have the right to buy options but are not obligated to do so. They can exercise this right but only within the stipulated time and under the agreed conditions. This way, call and put holders only suffer losses equivalent to the premium charged for the options contract.  

Call and put writers are sellers. They have an obligation to sell options or buy should the option expire, and the contract makes money. Therefore, sellers are always expected to oblige to the buyer’s wishes. This exposes them to more risks. Therefore, writers stand to lose a lot more than just the cost of writing the options contract. 

Example  

Think about this company that you really like such that you would like to become a shareholder. According to your predictions, the stock price is going to rise. For instance, the current stock price of this company is $25 but you believe the price will be $35 in a year’s time. You can purchase a call option that will grant you the rights to purchase the stock.  

On the contract, you can agree to a price of approximately $27 within the succeeding year. This contract will most likely cost you close to $1 per 100 shares. Now if the price does get to $35 as predicted, then you can exercise your right to buy the shares at $27. However, if the price remains constant or falls, you will not be obliged to buy and the only loss you will incur is the options fee. 

Basic Put and Call Options Chain 

This is a specific chain that is among the most popular options chains used by investors and traders, especially beginners. It is an excellent choice for those seeking to learn more about options.  

This chain presents a split table with put options to the right and call options to the left. The different strike prices relevant to the options run to fight down the center of the table. This way, investors and traders can easily track put and call options of various strike prices.

If we closely examine the options chain above, we note that the strike prices run through the middle from top to bottom. We also note that the put options are located on the right side while the call options are on the left-hand side. 

Other parameters such as bid price, last price, ask price, volumes, price change from the preceding trading day and open interested are displayed for both put and call options. When it comes to trading or investing this chain is the most widely used.  It is popular with traders basically because it presents a lot of the information, they consider crucial.  

Important information necessary to execute trades is presented in a simple manner that is easy to read and understand. Using this chain, a trader can easily trace and identify the available call and put options as well as other parameters affiliated to each option. However, this chain is most suitable for traders interested in simple options trading strategies. There are other chains suitable for more complex strategies. 

The Call and Put Options Price  

The put and call price is a chain that presents the necessary data relating to basic call and put options.  It also projects each option with five option Greeks. This way, an investor or trader who needs to use delta neutral options trading strategies and arbitrage strategies. The trader will be able to make exact calculations regarding size and position to take effectively.   

Looking at a relevant chain, you will easily note that all the five Greek symbols that include Vega, Rho, Theta, Gamma and Delta are used. They are visible in the call and put options price. However, due to challenges in full-screen presentations, options prices usually present as either put options or call options only. 

Options Strategies Chains  

Specific options strategies chains are ideal for options traders or investors who prefer standardized options strategies like the covered call or the long straddle. The reason is that these chains drastically reduce the amount of work necessary to work out and calculate the options outlay as well as other specifics that relate to the specific strategy. 

Options chains like this one generally present only the essential aspects of an options trading strategy across the various expiration dates and strike prices. This way, it can easily calculate and work out the net effect of a position and plenty of other useful detail. This way, a trader can make quick decisions on the spread to choose fast without spending time doing calculations and working out arithmetic.  

Call and Put Options Matrix 

This chain is the least used by investors and traders, especially beginners and retail options traders. The aim of this chain is to present information on many options including their bid and ask prices over numerous expiration dates all on one page. 

This options matrix generally presents only bid prices for all options listed on the chain but without additional information. This makes it a less useful table especially for beginners, amateurs, and retail traders who basically need a lot more information. However, it is considered by many traders to be the least useful chain out there. 

Learn about Options Pricing  

Another useful aspect of options trading that you need to be familiar with is the aspect of pricing options. The option price is also known as the option premium and consists of two distinct components. These are the intrinsic value and extrinsic value. Both are governed by the Put-Call Parity principle.  

Tips for Buying Call Options  

Do not buy a call option with a strike price that you do not think the stock can beat.   

Always include the premium price in your analysis.  

Look for calls that are just in the money. These are likely to bring a modest profit.   

Call options that are out of the money might give you an option for a cheaper premium.  

However, the premium should not be your primary consideration when looking to buy a call option. Compared to the money required to buy the shares and the potential profits if the stock goes past the strike price, the premium is going to be a trivial cost in most cases – provided of course the strike price is high enough to take the premium into account.   

Look at the time value. If you are looking for larger profits, it is better to aim for longer contracts. Remember, that with any call option you have the option to buy the stock at the strike price at any time between today’s date and the deadline when the stock market price exceeds the strike price. Longer time frames mean you increase the chances of that happening. Even if the price goes a little above the strike price and dips down, with a longer window of time before the deadline, you can wait and see if it rebounds. Remember if it never does, you are only out the premium.   

Start small. Beginning traders should not bet the farm on options. You will end up broke if you do that. The better approach is to start by investing in one contract at a time and gaining experience as you go.  

The best-case scenario for you, as the buyer, is that the stock suddenly starts rising at a high speed before the deadline arrives. You want it to go beyond the strike price so that, when it comes time to exercise your right, you are purchasing your stock at a lower rate than it is now worth. Obviously, you then have the option to instantly list that stock as a covered sell, which would allow you to realize that profit in real money.

That final piece of the puzzle is the important one. As an options trader, you are not in the business of building a stock portfolio. You do not really want to own those shares – you want to make a profit on them as they pass through your hands. You want to buy them for less than they are worth and then sell them on, perhaps even for more than they are worth if you are lucky. It is within that transaction your money will be made.

Buying calls has several advantages for you as an options trader:

It does not cost much to get involved in the movement of a stock. You only need fork out the amount for the premium, after which you can sit back and wait to see what the stock does before making your purchase decision based on actual information, rather than on speculating what the market will do. 

It allows you to make use of the kinds of “tips” that market experts have a bad habit of swearing by. You read the news, you are watching the markets and you have information that makes you think a certain stock is about to rise fast and hard. You want to take advantage of that, obviously, and options trading allows you to do so much more safely than simply buying the stock. If you are wrong, you will only lose your premium and you may even make a small profit. If you were wrong and purchased the stock and then it plummeted rather than rose, you stand to lose a whole lot more cash.