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Option Volatility

Option volatility is frequently determined based on the Black Scholes model, which was an option pricing model that was developed in 1973 by Fisher Black and Myron Scholes.

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Option Volatility Analysis

Calculating a fair market value for options with this model is achieved by using several variables including strike price, expiration, and historical volatitly. It is not likely, though, that option traders will actually determine an option’s market value before choosing to establish a position. It’s quite interesting that traders would not assess the fair market price of various options before choosing to establish a position because this would not be typical behavior in any other market, such as real estate or the auto industry.

Necessity of Option Volatility Analysis

In general, value analysis is not needed based on the trader’s outlook because the value of an option can change rapidly. Greed is generally at the basis of traders choosing not to conduct a value analysis on options. The problem with this is option volatility and that the price may decrease when a trader expects it to increase based on an anticipated move. Options pricing can respond differently than anticipated and for traders to make the most of trades they should understand implied volatitly and how it plays into option pricing.

Explanation of Option Volatility

The change of price of the underlying, whether it goes up or down, is measured as volatility. This element is of importance in determining the option prices. For example, should option volatility be high then the premium would also be so. However, if the volatility of the option is low then the option premium would be low. When an underlying has a measureable statistical volatility then the fair market value for the option may be determined by using a standard options pricing model.

The actual market value and fair market value are not always in line with one another, which is called option mispricing. This begs the question why a model even exists if the theoretical value from the model does not line up with the option price. The reason this occurs is based on the implied volatility that has been included in the option. The current market price, statistical volatility and implied volatility are all calculated with the models. For example, when the current option price is plugged into the model the implied volatility is determined. The change in premium price and option price is typically related to implied volatility pricing.