Throughout my recent series on when and which option to buy, we used a theoretical example of a stock that starts at 70, moving up by 1-point increments to 73; its implied volatility is 40; and interest rates hold steady at 1% with no dividends. It's rarely the case in the real world that the only variable that changes is the price of the underlying, but I was holding these variables constant to explain the theory that options with different expirations react differently to underlying price movements.
 

To attempt to forecast options prices in my blog examples, I used TradeKing's Options Calculator, found under Tools (don't forget to login first). Since I was using a theoretical example, I didn't enter a stock symbol. Instead I inputted the other data directly into the calculator and hit re-calculate. First I focused on changing the stock price point by point, observing how that movement impacted options prices. Then I changed the "days to expiration" to a different time frame and repeated the entire process over again.



Although this is a solid theoretical example, in practice there are other variables to think about. One variable that changes often is implied volatility (IV); in fact IV may be different between different contracts in the same option chain. This variance of IV between options of the same underlying is called "volatility skew", and understanding it is critical to options trading. I'd strongly encourage you to take 10 minutes to read my volatility skew post before moving on here. (While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.)

I bring this up because there is a faster way to forecast option prices using an option chain. Not only is this method faster, I believe it to be a little more realistic because is it uses real data in the marketplace and does account for the volatility skew mentioned above, unlike the Options Calculator that holds every variable (including volatility) constant.

So here goes: you might have to read twice to grasp the concept, but trust me, it's worth it. This little trick is great to help you develop realistic expectations on what your long option contract might do if your forecast is correct or incorrect. Check out the options chain below on theoretical stock XYZ. (This concept should work no matter if a stock or index is used.) I have boxed the ASK prices from the 110 strike to the 117 strike. To simplify things, we'll assume we can buy and sell on the ASK price; in the real world, you buy on the ASK and sell on the BID price.



The current market for XYZ is 113.64, so let's start by looking at the 113 call strike. The 113 call strike is in-the-money (ITM) by 64 cents (113.64 - 113), and its asking price is $4.10. If we bought this option, the commission would be $5.60 at TradeKing and the max loss would be the price paid, or $4.10. Now if XYZ went down a point to 112.64, the 113 call would be 36 cents out-of-the-money (OTM) (113 - 112.64). On the chain above the 114 call was 36 cents OTM and was trading for $3.50. Again, it's reasonable to conclude that if the stock moved down one point to 112.64 and made the 113 call 36 cents OTM, that call should trade for around $3.50. If you did not grasp 100%, keep reading.

• Here we are using one-point strikes which makes it easy. If the width between the strikes is 5 points wide, you could only attempt to forecast a 5-point move in the underlying - nothing smaller. 
  
• The example assumes the move happens today and the variables in the marketplace are fairly constant. If the move takes a couple of weeks the movement may be different than anticipated because of time decay and other factors that may have changed.
  
• It does help that the volatility skew is in the attempted forecast. Below the black box highlights how options trade with different implied volatilities, depending on how much they are in-at-or-out-of-the-money. Since we are using the direct data from the chain, volatility skew is being factored into our attempted forecast.

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options available at http://www.tradeking.com/ODD.

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