Option contracts are opportunities, not obligations, to purchase shares of the underlying stock, and the valuation methods depend on a number of factors. The first factor in option valuation is the price movement of the underlying stock. Next is the strike price, or how much you have to pay for the options contract. Then there is the time to expiration. Each option contract has an expiration date and the closer to expiration the lower the strike price. The final factors in option valuation methods are the volatility and dividends of the underlying stock and the tax-free interest rate that an investor could earn with safer investments.
When applying option value assessments to the purchase of an options contract, you should consider personal and individual business investment preferences such as risk aversion, required rate of return and other microeconomics factors. Options valuation techniques factor in the market or external factors and it is up to each business or individual to determine if the risk is bearable and the potential rate of return helps improve the risk factors.
To begin using option valuation techniques to assist in this decision, consider the following:
1. Know the basics of the valuation of options.
2. Understand the theories of option pricing techniques.
3. Utilize software to compute the option valuation technique.
Action Steps
The best contacts and resources to help you get it done
Study the basic structure of options pricing
Before anyone can understand option pricing theories, a thorough study of the fundamental pricing of options is necessary. Think of it in terms of a swimming lesson; the lesson would not start in the deep end of the pool. It is same with options pricing; wade into the shallow end and gradually work your way from there.
I recommend: Read the basic concepts behind the
trading of options. The
Chicago Board Options Exchanges (CBOE) has an excellent primer on options trading. Beyond the primer, the CBOE offers
The Options Institute, which offers webinars, online courses and much more to learn all about options pricing and trading.
Evaluate the main option valuation techniques
Black-Scholes and Binomial are the two main option valuation methods that traders use today. There are others, such as the Monte Carlo simulation and the Samuelson-McKean formula, that are gaining credence, but Black-Scholes and Binomial still lead the way in option valuation theory.
I recommend: Learn the essentials to calculate the option pricing using the
Black-Scholes and
Binomial methods. Then study the way these models use various factors to compute the correct options pricing.
Purchase software that can compute the options valuation techniques
Now that you have understanding of each option pricing model, download software that will make these complex calculations.
I recommend: Download and purchase an add-on for
Microsoft Excel to begin using these options pricing theories. You can also purchase
stand-alone software that offers more robust options valuation techniques.
Tips & Tactics
Helpful advice for making the most of this Guide
- Be sure that whatever money you invest in options is money that you can afford to lose. No matter how thorough the research, every investment carries significant risk and you can lose your entire investment.
The official source of Option Valuation Techniques is
the Option Valuation Techniques page at Business.com
Related Resources from Business.com
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