To the novice investor the complexity of the options market can seem overwhelming at times. Given the multitude of strategies as well as the numerous variables affecting an option’s price, it requires time and effort to fully understand how these instruments work.
Fortunately, there are a variety of tools made available by brokerage houses, exchanges, and educational sites that aid in the learning process. While some of these tools are easy to use and very useful, others are complex and not worth the hassle. One of the more valuable tools made available by virtually every broker or website tailoring toward options trading investors is the options calculator. The power behind this particular tool is its ability to show exactly how an option is priced.
To be frank, I see the option calculator as a tool most useful for beginning traders seeking to learn the nuances of option pricing. It is not frequently used by professional option traders in the decision making process and I don’t consider it an essential tool for finding or placing option trades. That said, these calculators work for many options traders.
After scouring the net for a free, simple to use calculator the one that seemed to standout the most was offered by IVolatility. Due to its easy to use nature it is also the calculator of choice on the Chicago Board Options Exchange (NASDAQ: CBOE) and The Options Industry Council site.
By design the option calculator lists the six variables or inputs that are used to calculate an option’s price. As shown in the graphic above these include the stock price, strike price, days to expiration, volatility, interest rate, and dividends. After inserting this data the calculator will show the value of both call and put options on the right hand side along with their respective Greek values.
Find more option analysis and trading ideas at Options Trading Strategies.
Experimenting with the calculator can be a powerful exercise in learning what makes an option tick. When practicing with the tool try increasing or decreasing each one of the inputs to see the effect it has on the option’s price. What happens to the value of both options as you increase the volatility? What happens as you decrease the time to expiration? How about changing the strike price? Discovering the answer to these questions will help you make more informed decisions about your option trades going forward.
Another revealing feature of the calculator is the ability to see how these inputs affect the Greeks, those options theoreticals that impact the basis pricing decisions.
Try changing time to expiration or the strike price and see how the Greeks change. You’ll begin to identify patterns emerging as you change from one strike price to another. As you move from one month to the next you’ll also see how the Greeks differ between long term options and short term options.
A bonus available in the IVol calculator that’s not often included elsewhere is the ability to calculate implied volatility for a specific option. Experimenting with this feature reveals the relationship between a rising implied volatility and rising option premiums.
Follow Tyler Craig on Twitter@TylersTrading.