When it comes to buying and selling options, most traders, whether beginners or experts, know a little about the Black-Scholes model of option pricing. This model, developed by Myron Scholes and Fisher Black in 1973 was invented to help traders determine what the market value of an option was based on expiration time, strike price, and historical volatility.

For some reason, though, many traders don’t use this, or even an option calculator for that matter, to determine the fair price of their options before they purchase them.

This type of behaviour generally occurs because traders believe that an option’s value can increase when a call or put option is exercised. While this may be the case in some situations, you have to stop and think about the many variables that tend to get in the way.

Think about this for a moment; would you buy a car or home without researching the neighbourhood first and determining the fair market price? You wouldn’t, because you would be concerned about paying too much or not being able to sell the asset at the right price later on. In the case of options, deciding to purchase without careful assessment can actually lead to a lower option value because the expected move of the derivative has already been factored into the price.

To truly understand the mysteries of option pricing and understand why careful assessment is needed, a good look at volatility is needed. In the following, we will discuss what volatility is and how this important element can affect your option pricing.

Option Volatility Explained

Volatility is an element used when calculating option pricing and is defined as the measure of the magnitude and rate of the price change of a derivative. This refers to both changes that increase and decrease. When volatility is high, the price of an option is high; when it is low, the option’s premium will reflect it.

There are two types of volatility:

• Historical Volatility – This type of volatility, also called statistical volatility, refers to the known changes in an option’s price. These changes are known because they are actually based on recent changes that have occurred with a derivative. This type of volatility has a rate of change, similar to a car speeding down the road. While we can measure the speed of the car over an hour, we can do the same with this changing rate as well, although it is done over a course of a year. If the derivative has been moving along at a certain rate per year, we can theoretically expect it to move at the same rate in the future. However, this does account for trend or direction.
• Implied Volatility – Implied volatility takes things a step further than historical, by using the historical data and the current market prices to determine the option price. Typically, the current price is calculated using two of the closest out-of-the-money strike prices. This type of volatility has a huge effect on the price of options, because it depends so much on the activity of the marketplace. As a result, when implied volatility increase, the option prices does too, as long as other factors remain the same.