Learning the options pricing theory and strategies basics can help you make wise investment decisions. As with other investments, gaining a better understanding about the factors affecting option pricing and how to calculate the fair value of options is a critical step in taking advantage of the market.

Option pricing strategies are the systems or models used to determine the option’s fair value. There are a range of options pricing theory and strategies from which to choose, including the binomial model and the Black-Scholes model, two methods widely used in the financial market. Consider the following tips to help you learn the options pricing theory and strategies basics.

1. Research how to use the Black-Scholes model to calculate option pricing.

2. Assess the advantages of using the binomial option pricing theory.

3. Learn more about other options strategies.

Action Steps
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Learn more about the Black-Scholes option pricing theory

Created in 1973, the Black-Scholes model marked the commencement of the modern era for calculating options pricing and has become one of the most widely used options pricing theory in the current financial market. The Black-Scholes model is based on several assumptions. Volatility is an assumption of the Black-Scholes options pricing model, which measures a stock's expected movement in the near-term and over time. This model also assumes that stock pricing is equally likely to move up than it is to move down at any given moment. Based on these two assumptions, the Black-Scholes model presents a set of calculations that you can use to determine option pricing.

I recommend: Check out the Economic Research Institute to learn more about the basic calculations used in the Black-Scholes options pricing theory. You can also learn more about the Black-Scholes stock option valuation theory by visiting wiseGEEK.

Take a closer look at the binomial option pricing strategy

The binomial options pricing theory makes some of the same assumptions as the Black-Scholes options pricing model, but it's more versatile in that you can use the binomial options pricing model to determine U.S. options pricing, as well as, complex derivative securities. This options strategy creates more accurate calculations for longer-dated options than the Black-Scholes model. In addition, the binomial options pricing model is fairly simple from a mathematical perspective, therefore making it easy to implement in a software or spreadsheet tool.

I recommend: Read more about the basics of the binomial options pricing theory by visiting Wolfram Demonstrations Project. You can also visit the blog belonging to William C. Spaulding to find out more about the binomial options pricing theory.

Evaluate other option pricing strategies

In addition to the Black-Scholes model and the binomial model, there are a variety of other option pricing strategies available to help you determine the fair value of options. These include finite difference schemes and Monte-Carlo stock option valuation methods. Consulting with options brokers can help you determine which options pricing model is best for you.

I recommend: Check out the website provided by Peter Hoadley to read more about the basics of other options pricing theory and strategies. You can also find more information about the options market by visiting the Contingency Analysis website.

Tips & Tactics

Helpful advice for making the most of this Guide

• •  Before you can take full advantage of the market, it's important to learn about the primary factors that affect options pricing. These factors include the current stock price, volatility of the market, intrinsic value and the amount of time left before an option expires.

Investing always carries some measure of risk, especially in the world of options trading. It's more likely be rewarding if you’ve done your homework first. When trading options or looking into stock option valuation for your employees, you first need a basic knowledge of option pricing. Option pricing theory consists of numerous models, as option pricing is a complex process determined by a multitude of variables along with an asset’s principal value.

Because options pricing strategies are intricate and varied, it’s a good idea to solicit advice from an expert source before beginning to trade options. Options brokers can help you understand the various pricing theories, and will also offer efficient means of trading options.

When exploring options trading, here are some key steps to remember:

1. Understand the basics of options pricing theory before you start trading.
2. Study the options market to ensure you’re trading at an optimal time.
3. Choose an investment account that you are comfortable with and that fits your investment background and experience.

Action Steps
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Research online to better understand option pricing theory

Even if you understand the basics of options pricing, talking to an expert or consulting a guide will solidify your knowledge of options trading before you make financial decisions. Find a broker online who can offer personal advice on options pricing strategies before trading options through their firm.

I recommend: InvestBrite offers a number of guides from various investment websites that explain option pricing strategies when you register with their website. The Options Investigator is free and offers comprehensive educational software on options trading. For detailed information on the theory behind stock option valuation, see Investopedia or review the definition of option valuation from Duke University.

Put your knowledge of option pricing theory and strategies to the test

When you think you're ready to start trading options, first test your skills on software that lets you practice with real-time market data. Try different free software programs that allow you to assess your knowledge of option pricing theory using fake money before risking your own.

I recommend: Register with Forex for a free demo account to use their ForexTRADER software platform under current market conditions, or login to Stocktrack.com with a free demo account to practice options trading with their market simulator.

Start trading with an options broker who offers online services

Once you fully understand option pricing theory and strategies, online trading is the quickest and most efficient way to trade options. Many brokerage sites offer online trading.

I recommend: Scottrade offers online options trading pending approval from your local broker, while optionsXpress presents trading through their convenient Options Order Form software. Orion Futures Group offers a number of different accounts depending on your experience with and knowledge of option pricing strategies.

Tips & Tactics

Helpful advice for making the most of this Guide

• •  Shop around for an online broker who will give you the best deal when trading options, so you can make the most from your options strategies education.

Making the most of options pricing theory and strategies can help you determine the most beneficial model to assist you with your investments. Option pricing strategies can be defined as models used to determine the option’s fair value.

The binomial model and the Black-Scholes model are two widely used option pricing strategies that have wide error margins, because their values are calculated from other assets, such as a business’ common stock prices. Consider the following tips on making the most of options pricing theory and strategies.

1. Assess the primary drivers of option pricing.

2. Compare commonly used option pricing strategies.

3. Consult with an options broker to assist you in making the most of options pricing theory and strategies.

Action Steps
The best contacts and resources to help you get it done

Evaluate factors affecting option pricing

To fully understand and make the most of options pricing theory and strategies, you must first learn about the primary factors that affect the price of an option. These factors include the current stock price, volatility of the market, intrinsic value and the time left before an option expires. The current stock price is directly related to options pricing. As the stock price increases, the more likely the option price will decrease and vice versa.

I recommend: Check out the website of the Foster College of Business at Bradley University to learn more about making the most of options pricing strategies. You can also find more information about option pricing strategies by checking out the Options FAQ from The Options Industry Council.

Learn about the advantages of various option pricing strategies

When compared to other option pricing strategies, the binomial model is mathematically simple and somewhat easy to create and implement using computer spreadsheets. This option pricing strategy, created in 1979, also reduces the possibility of price changes and makes the assumption that the market is efficient. The Black-Scholes model, created in 1973, has become a key options pricing theory in today's financial market. This model is widely recognized as one of the most practical ways to calculate the fair value of options.

I recommend: Visit QuickMBA.com to learn more about making the most of the Black-Scholes option pricing theory. Then, you can read more about the binomial options pricing strategy by visiting Investopedia. This information will make it easier for you to choose which trading strategy for options works best for you.

Seek professional advice on stock option valuation

Conducting research is a great way to familiarize yourself with the common terms and methods to determine option pricing, but to fully make the most of the option pricing strategies, you may consider seeking advice from options brokers. They can help you learn when to use which option pricing theory to accurately determine the fair value when trading options. They can also provide insight on your investments.

I recommend: Check out Empire Valuation Consultants for more information about options pricing strategies. You can also receive advice on options pricing from Radford consultants.

Tips & Tactics

Helpful advice for making the most of this Guide

• •  Stock option valuation has become a hot topic in recent years because U.S. businesses are required to now record the cost of employee stock options as an expense on their earnings statements. Expect the creation of innovative options strategies to help traders accurately and consistently address this increased expense.

Options are a valuable financial instrument for people who want or need flexibility when they invest. Whether investors expect stock prices to rise or fall, options give investors the right (but not the obligation) to either buy or sell stocks sometime in the future. Options pricing is more of an art than a science, but investors and financial researchers have come up with a number of ways to find fair market value using basic information.

Action Steps
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Black-Scholes model

The Black-Scholes model is the standard formula for options pricing. Published in 1973, the model takes into account several important variables that contribute to the option's fair market value.

I recommend: For a thorough discussion of the Black-Scholes method and other pricing theories, visit Contingency Analysis. To learn more about the actual math behind the model, head over to QuickMBA.com.

Strike price

The strike price is the price at which brokers buy or sell the option's underlying asset, or stock, when the option expires. Buyers of call options hope stock prices rise above the strike price.

I recommend: TheOptionsGuide.com offers a basic introduction to strike prices.

Intrinsic value

An option's intrinsic value reflects how much money the buyer would receive if he or she exercised it today. Along with the option's time value, intrinsic value is the main variable in calculating the option's price.

I recommend: To understand intrinsic value and how it relates to different types of options, read the introduction to options pricing at Investopedia ULC.

Time value

An option's time value is the difference between price and its intrinsic value. In general, the longer an option takes to expire, the greater chance the buyer has of turning a profit.

I recommend: Options Trading Beginner has a number of well-written articles on the time value of options.

Volatility

Volatility measures how likely the option's stock price is to change. It's hard to measure, but it's one of the best ways to estimate the buyer's risk in purchasing the option.

I recommend: The Options Industry Council outlines the basic variables in options pricing, including volatility, on its website.

In the money

If an option has a positive intrinsic value, then investors say it's 'in the money.' In simple terms, this means the option would yield a profit if exercised today.

I recommend: The Motley Fool has published a useful guide to options pricing that explains the terms "in the money" and "out of the money."