Most options traders – from beginner to expert – are familiar with the Black-Scholes model of option pricing developed by Fisher Black and Myron Scholes in 1973.
To calculate what is deemed a fair market value for any option, the model incorporates a number of variables, which include time to expiration, historical volatility and strike price. Many option traders, however, rarely assess the market value of an option before establishing a position.
This has always been a curious phenomenon, because these same traders would hardly approach buying a home or a car without looking at the fair market price of these assets. This behavior seems to result from the trader’s perception that an option can explode in value if the underlying makes the intended move. Unfortunately, this kind of perception overlooks the need for value analysis.
Too often, greed and haste prevent traders from making a more careful assessment. Unfortunately for many option buyers, the expected move of the underlying may already be priced into the option’s value. Indeed, many traders sorely discover that when the underlying makes the anticipated move, the option’s price might decline rather than increase.
This mystery of options pricing can often be explained by a look at implied volatility (IV). Let’s take a look at the role that IV plays in option pricing and how traders can best take advantage of it.