Options Pricing Theory and Strategies Key Terms
Learn the language of options pricing to better understand theories
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.
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.
Try: 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.
Try: 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.
Try: 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.
Try: 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.
Try: 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.
Try: The Motley Fool has published a useful guide to options pricing that explains the terms "in the money" and "out of the money."
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