Options Pricing: Use the Black-Scholes Model to Get a Fair Price for Your Options
by Karim Rahemtulla, Options Expert
Tuesday, August 31, 2010: Issue #1335
Picture the scene…
You’ve just spent several hours researching a company that you want to invest in.
You’ve conducted all your due diligence on the stock from a fundamental and technical standpoint.
You decide how many shares or options contracts to buy and pull the trigger.
But right off the bat, you find yourself on the losing end of the trade – and the stock/option hasn’t even had a chance to do anything!
Your problem is that you might not have paid enough attention to two vital numbers. And they’re particularly important numbers in the options world…
Are You “Spread Savvy” with Option Pricing?
When it comes to LEAP options especially – those that expire in one year, two years, or more – their long-term nature means they sport some unique characteristics.
The most obvious one – and one that will cost you dearly if you’re not aware of it is the spread. In other words, the difference between the “bid” price and “ask” price.
 The Spread
Whether you’re talking about stocks or options, the spread refers to the amount between the bid and the ask. Bid: This is the price at which a buyer will purchase shares/options contracts from a seller. The closer to the bid you can buy, the better your purchase price. Ask (also called the “Offer”): This is the price at which a seller will offer shares/options contracts to a buyer. The closer to the offer that you can sell, the better your sale price. |
The goal is always to buy between the bid and offer.
The Force Behind the Spread
When it comes to spreads, the key is liquidity. In other words, the amount of shares or options that trade hands for any given security. Most of the time, the liquidity determines the spread.
About 10 years ago, stocks and options used to trade with fairly wide spreads – eighths and quarters were the norm. But recently, stocks started to trade with penny spreads – a huge boon for the investors.
In the options world, contracts mostly still trade with spreads of a nickel or dime, except for those that are very active. Examples include Microsoft (Nasdaq: MSFT), General Electric (NYSE: GE), Bank of America (NYSE: BAC).
However, the further out you go in expiration, the wider the spread becomes. For example, a GE option expiring in September might trade with a penny spread. But one that expires in March may have a two or three cent spread.
There are two reasons behind wider spreads…
- Liquidity, as I mentioned above.
- Time. The seller of the option has to absorb more risk when an option has a longer expiration. That extra risk is factored into the spread. It doesn’t mean you have to necessarily pay more, though.
With LEAP options the situation is magnified…
Three Guys… One Model… And the Key to Paying a Fair Price for Options
Depending on the price of the option, some LEAPS trade with 10-cent spreads, while others could be as high as $1 or $2.
I’ll give you a recent example from my Smart Cap Alert service. We decided to play a company whose shares were trading around $10.50 and I recommended buying the $12.50 options, which expire in 2012. The bid was $1.50 and the ask was $2.20 – a full 70-cent spread. That’s huge. And you can see how it would affect your returns if you bought at the ask and had to sell at the bid. You’d take a 35% hit immediately.
So how do you find out what an option is really worth?
The answer lies in the Black-Scholes model.
| The Black-Scholes Model
In 1973, three economists – Fisher Black, Myron Scholes and Robert Merton – created the model for options pricing. The model takes factors like risk, time, volatility, strike price and the underlying share price into account to come up with a fair, realistic value for options. Scholes and Merton won the 1997 Nobel Prize for Economics for their work (Black died in 1995 and was ineligible for the award.) To get the Black-Scholes calculator, just type “Black-Scholes calculator” into a Google search. |
When I plugged the factors into the model for the Smart Cap Alert recommendation, it came up with a value of $1.60 for the option.
That was the strict limit price we used to buy the option. And guess what? Everyone who wanted to buy it was filled at that price or better over a period of a few days, even though the spread remained wide.
So the next time you want to buy an option, but it’s trading with a wide spread, do not automatically pay the ask price. Instead, do the following:
- Use the Black Scholes calculator to come up with the real value for the option.
- Check each options exchange. There are several and one might be offering the option at a lower price.
- Place buy orders closer to the bid and move up in penny or five-cent increments.
Unless you’re in a real hurry to place your bet, remember that the value of an option decays every day because of the reduction in time value. So if you don’t get it today, try again tomorrow.
Good investing,
Karim Rahemtulla
Related Investment U Articles:
- Put Option Credit Spreads: Three Ways to Win – And an 80% Chance of Success
- Be the Pit Boss of Your Own Options Casino
- LEAP Bear Spreads: If You Want to “Go Short,” This is the Way to Do It
- LEAP Option Spreads: Tame the Market With This Risk-Blasting Strategy
- The Legged Spread Trade: Take 10 Cents and I’ll Show You How to Make It $2.50
7 Responses to “Options Pricing: Use the Black-Scholes Model to Get a Fair Price for Your Options”
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Dubbed a "market maven" by CNBC, Karim Rahemtulla is one of the country's foremost specialists in options trading. As founder and editor of The Smart Cap Alert, he focuses his efforts on all aspects of options trading – LEAPS, put selling/covered calls and spreads. 
Great article – but where do I find the volatility entry for any particular stock?
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I too would like to know where to find the volatility and risk free rate of returns. Without this info, the model is useless.
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Karim; Excellent article as always,but, by your examples the seller of the LEAPS was willing to ASK $2.20, bid was $1.50; but by your ” What’s It Mean ” the bid is the seller? Was this a mix-up? I always thought the Ask was the seller, the Bid was the buyer.
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i THINK YOUR INITIAL DEFINITION OF BID AND ASKED IS REVERSED. THE BID IS A BUYER AND THE ASKED IS A SELLER.
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Same question: where is the volatility for a stock. A linked page mentions beta but that is obviously not it. VIX is for the whole market. Another linked page to CBOE has a further promising link that no longer exists…
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I tried to use your B-S calculator.
Several problems:
No dates beyond Jan 2011
Very little relationship with the quoted Bid/Ask
Can only do one strike price at a time.
I remember a website attached to a discount broker which used to display multiple B-S numbers at a time (and I did not even have an account with them). I would like to know who, if anyone, still offers this quite-complete service?
Thank you.
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This is not an ad for OptionsXpress. I have an account there and they have a tool called ‘pricer” which automatically plugs in the implied volatility for any stock and shows you the price of the options. Other than that, I don’t know where to find the IV number.
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