Options pricing was revolutionized in 1973 with the publication of the Black-Scholes Model, the Nobel-prize winning equation which virtually created the options marketplace. While looking at this formula completely written out would be, for most people, absolutely confounding, a comprehension of options pricing is well within the realm of understanding of anyone with simple math skills.
Let's analyze the different components which are used to determine the theoretical value of an option:
- The price of the underlying stock
- The strike price of the option
- The time until the option expires
- The cost of money (interest rates less dividends, if any)
- The volatility of the underlying stock Historic or implied volatility?