Ever wondered where options prices come from? Far from arbitrary, options prices reflect diverse factors like time to expiration, volatility, interest rates and other drivers. Options prices also reflect probabilities of the underlying reaching certain prices. This post gives a quick summary of these factors, plus additional reads to learn more.

I get this question frequently at trade shows: “Where do options prices come from?” Unlike a stock, you can’t take the book value and P/E ratio and simply round up or down for market forces in either a bullish or bearish direction.

But options prices don’t pop out of a magic hat. They’re calculated using an options pricing model, perhaps the most popular of which is the Black-Scholes model. This mathematical model takes into consideration various factors that impact an option’s value and therefore its price: volatility, time to expiration, interest rates, and price changes in the underlying among others.

Math-nuts may enjoy digging into these mathematical models, but even if you’re not, you can still get a handle on options prices when you consider their original objective of hedges of existing positions. Traders still use options as hedges or protection against developments that could negatively impact their trades. While options aren’t insurance products, many of the factors influencing their pricing are similar to those influencing an insurance policy’s pricing. Check out my post on options pricing considered in insurance terms for more.

While you’re at it, take a read through my two-part series on implied volatility, options prices and a trade’s overall probability of success. (Here’s part 1 and part 2.)

You might also want to check out our Probability Calculator – login, go to Tools > Probability Calculator, then look for the “Watch Video Demo” link in the upper right-hand corner of the page.

After all this, you may be able to resist the temptation to buy cheap options simply because they’re cheap. This post Cheap options = lottery tickets will explain why that can be a waste of your trading capital.

Feel free to send me your questions on this! Options pricing doesn’t need to be mysterious if you educate yourself on the factors driving those prices.

Regards,
Brian Overby
TradeKing's Options Guy
www.tradeking.com

[image: Magic by alancleaver_2000 on flickr]

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