Options Pricing: Distinguishing Between Option Premiums And Theoretical Value
  1. Options Pricing: Introduction
  2. Options Pricing: A Review Of Basic Terms
  3. Options Pricing: The Basics Of Pricing
  4. Options Pricing: Intrinsic Value And Time Value
  5. Options Pricing: Factors That Influence Option Price
  6. Options Pricing: Distinguishing Between Option Premiums And Theoretical Value
  7. Options Pricing: Modeling
  8. Options Pricing: Black-Scholes Model
  9. Options Pricing: Cox-Rubenstein Binomial Option Pricing Model
  10. Options Pricing: Put/Call Parity
  11. Options Pricing: Profit And Loss Diagrams
  12. Options Pricing: The Greeks
  13. Options Pricing: Conclusion

Options Pricing: Distinguishing Between Option Premiums And Theoretical Value

It is important to differentiate between an option premium and its theoretical value. As discussed previously, the option premium is the price the option buyer pays to the seller in order to have the right granted by the option, and it is the money the seller receives in exchange for writing the option.

The theoretical value of an option, on the other hand, is the estimated value of an option – a price generated by means of a model. It is what an option should currently be worth using all the known inputs, such as the underlying price, strike and days until expiration. These factors often change during an option's lifetime, and some fluctuate in value on a continuing basis throughout any trading session.

A pricing model will create theoretical values, but they are just that – theoretical. Specific values for each factor can be used to predict an option contract's theoretical value at a given point in the future.

When options are first listed on a stock, for example, the market makers will not know what sort of implied volatility to use, so they must make educated guesses (theoretical values). The implied volatility will then change based upon the supply and demand for the options.

Options Pricing: Modeling

  1. Options Pricing: Introduction
  2. Options Pricing: A Review Of Basic Terms
  3. Options Pricing: The Basics Of Pricing
  4. Options Pricing: Intrinsic Value And Time Value
  5. Options Pricing: Factors That Influence Option Price
  6. Options Pricing: Distinguishing Between Option Premiums And Theoretical Value
  7. Options Pricing: Modeling
  8. Options Pricing: Black-Scholes Model
  9. Options Pricing: Cox-Rubenstein Binomial Option Pricing Model
  10. Options Pricing: Put/Call Parity
  11. Options Pricing: Profit And Loss Diagrams
  12. Options Pricing: The Greeks
  13. Options Pricing: Conclusion
RELATED TERMS
  1. Option Premium

    1. The income received by an investor who sells or "writes" an ...
  2. Time Value

    The portion of an option's premium that is attributable to the ...
  3. Implied Volatility - IV

    The estimated volatility of a security's price.
  4. Step Premium

    A type of option where the cost of purchasing the option is paid ...
  5. Call On A Put

    One of the four types of compound options, this is a call option ...
  6. Back Fee

    A payment made to the writer of a compound option in the case ...
RELATED FAQS
  1. How can derivatives be used to earn income?

    Learn how option selling strategies can be used to collect premium amounts as income, and understand how selling covered ... Read Answer >>
  2. How does implied volatility impact the pricing of options?

    Learn about two specific volatility types associated with options and how implied volatility can impact the pricing of options. Read Answer >>
  3. Do options make more sense during bull or bear markets?

    Understand how options may be used in both bullish and bearish markets, and learn the basics of options pricing and certain ... Read Answer >>
  4. Are there any risks involved in trading put options through a traditional broker?

    Explore put option trading and different put option strategies. Learn the difference between traditional, online and direct ... Read Answer >>
  5. How is implied volatility for options impacted by a bearish market?

    Learn why implied volatility for option prices increases during bear markets, and learn about the different models for pricing ... Read Answer >>
  6. What's the difference between a regular option and an exotic option?

    Before learning about exotic options, you should have a fairly good understanding of regular options. Both types of options ... Read Answer >>

You May Also Like

Hot Definitions
  1. Return On Invested Capital - ROIC

    A calculation used to assess a company's efficiency at allocating the capital under its control to profitable investments. ...
  2. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  3. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  4. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  5. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  6. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
Trading Center