You might have had success beating the market by trading stocks using a disciplined

process anticipating a nice move either up or down. Many traders have also gained
the confidence to make money in the stock market by identifying one or two good
stocks posed to make a big move soon. But if you don't know how to take advantage
of that movement, you might be left in the dust. If this sounds like you, maybe
it's time to consider using options.

This article will explore the factors to consider if you plan to trade options to
take advantage of stock movements. Options are derivatives contracts that give the
holder the right, but not the obligation, to buy (in the case of a call) or sell
(in the case of a put) an underlying asset or security at a pre-determined price
(called the strike price) before the contract expires. That right comes with a
price, called the option's premium. Understanding how to value that premium is
crucial for trading options and essentially rests on the probability that the right
to buy or sell will end up being profitable at expiration.

KEY TAKEAWAYS
Options contracts can be priced using mathematical models such as the Black-Scholes
or Binomial pricing models.
An option's price is primarily made up of two distinct parts: its intrinsic value
and time value.
Intrinsic value is a measure of an option's profitability based on the strike price
versus the stock's price in the market.
Time value is based on the underlying asset's expected volatility and time until
the option's expiration.
Option Pricing Models
Before venturing into the world of trading options, investors should have a good
understanding of the factors determining the value of an option. These include the
current stock price, the intrinsic value, time to expiration or the time value,
volatility, interest rates, and cash dividends paid.1

There are several options pricing models that use these parameters to determine the
fair market value of an option. Of these, the Black-Scholes model is the most
widely known.2 In many ways, options are just like any other investment—you need to
understand what determines their price to use them effectively. Other models are
also commonly used, such as the binomial model and trinomial model.

Let's start with the primary drivers of the price of an option: current stock
price, intrinsic value, time to expiration or time value, and volatility. The
current stock price is fairly straightforward. The movement of the price of the
stock up or down has a direct, though not equal, effect on the price of the option.
As the price of a stock rises, the more likely it is that the price of a call
option will rise and the price of a put option will fall. If the stock price goes
down, the reverse will most likely happen to the price of the calls and puts.3

The Black-Scholes Formula

The Black Scholes model is perhaps the best-known options pricing method. The
model's formula is derived by multiplying the stock price by the cumulative
standard normal probability distribution function. Thereafter, the net present
value (NPV) of the strike price multiplied by the cumulative standard normal
distribution is subtracted from the resulting value of the previous calculation.

In mathematical notation:

\begin{aligned} &C = S_t N(d _1) - K e ^{-rt} N(d _2)\\ &\textbf{where:}\\ &d_1
= \frac{ln\frac{S_t}{K} + (r+ \frac{\sigma ^{2} _v}{2}) \ t}{\sigma_s \ \sqrt{t}}\\
&\text{and}\\ &d_2 = d _1 - \sigma_s \ \sqrt{t}\\ &\textbf{where:}\\ &C =
\text{Call option price}\\ &S = \text{Current stock (or other underlying) price}\\
&K = \text{Strike price}\\ &r = \text{Risk-free interest rate}\\ &t = \text{Time to
maturity}\\ &N = \text{A normal distribution}\\ \end{aligned}

C=S
t
N(d
1
)−Ke
−rt
N(d
2
)
where:
d
1
=
σ
s

ln
K
S
t

+(r+
2
σ
v
2

) t

and
d
2
=d
1
−σ
s

where:
C=Call option price
S=Current stock (or other underlying) price
K=Strike price
r=Risk-free interest rate
t=Time to maturity
N=A normal distribution