Think or Swim Tutorial - The “Black-Scholes Model” - How to calculate the price of Options

This tutorial will introduce you with the Theoretical Price of an Option. By the end of this article you will be able to easily determine that price on your own and understand the dynamic behind all the Option Orders that Market Makers fill. If you find this tutorial interesting read also ThinkorSwim Tutorial - The Options' Theoretical Price and the Expected Price Calculator.

How to place the most rewarding options strategies from scratch? Visit my website at www.FromZeroToOptions.com to get tutorials, instructions, articles and much more stocks and options related.

--------------------------------------------------------------------------------------------------------

How Market Makers fill an Option Order

The price you have to pay to buy or sell any Option is directly related to a series of risks that the Market Maker, who is your counter-party, has to face.

First of all, in order to fill an Option Order the Market Maker must sell you one contract since it is in the opposite side of the trade. Never forget that whenever you buy or sell anything on the Stock Exchange there must always be somebody on the other side who is willing to trade with you at the agreed price.

The Black-Scholes Model

The Theoretical Price of an Option is determined by organising a package of asset into a risk-free position and then finding the today’s values of that package based on the current interest rate.

In order to understand how it works you have to understand how is made up the Theoretical Price of an Option . The Black-Scholes Model is the theoretical price model to calculate it. Actually, there are many of them and all bring to similar results, but the Black-Scholes one is the original and the most well-known. This model contains six pieces of information:

1. The Stock Price;
2. The Exercise o Strike Price;
3. The Risk-Free Interest Rate;
4. The Time to Expiration;
5. The Dividends are paid over the life of an Option;
6. The Volatility.

Once you have put in these pieces of information the model will tell you how much the price of a Call or Put Option should be.

--------------------------------------------------------------------------------------------------------

Do not forget to visit my website at www.FromZeroToOptions.com to get tutorials, instructions, articles and much more stocks and options related.

--------------------------------------------------------------------------------------------------------

Let’s suppose you want to know how much is worth buying a one-year $50 Call Option

By selling you the one-year $50 Call the Market Maker has unlimited upside risk. That’s because you have potential unlimited gains at its risk. In order to shield itself against that risk, it may decide to buy 100 shares of the underlying Stock which we’ll assume is also traded for $50. At this point there is a new risk for the Market Maker to cover because it is long for $5,000 Stock and short for the $50 Call it’s sold you. Because it owns the shares it is now facing the risk that the Stock price drops. To hedge that risk it can buy a $50 Put. Let’s do the assumption that it pays $2 for buying that Put or $200 total. To sum up, in order to protect itself against the market risk the Market Maker has to own a package of three assets:

• Long Call;
• Short $50 Call;
• Long $50 Put.

The package mentioned above is called a “Conversion ” and has the unique property to guarantee the sale of Stocks at a particular price. In this way the Market Maker is absolutely protected against any risk whatever happens to the underlying Stock. The “Conversion” assures that the Market Maker has the guaranty to sell its 100 shares in a year for $50 per share. There might be 3 different scenarios:

1. The Stock price is $50 at the end of the year. In such a case the Put and the Call Options expire worthless and the Market Maker can sell the shares in the open market for $50 each.
2. The Stock price is above $50 at the end of the year. In such a case the Long Put expires worthless and the Market Maker will get assigned on the $50 Call and it will have to deliver the shares for the $50 strike price. So again it will receive $50 per share.
3. The Stock price is below $50 at the end of the year. In such a case the Short Call expires worthless and the Market Maker will exercise its Long $50 Put and sell its shares for the $50 strike price. Once again it will receive $50 per share.

Free Tutorials - Stocks, Options and ThinkorSwim. Click Here.

In the next GroWithYou Trading Tutorial

• How the Market Maker determine the price of an Option
• The price of Options in Think or Swim
• How Think or Swim utilize the Option’s Theoretical Price calculation to help you make better decisions.
• Bonus - Free Mini Video Tutorial

Keep learning about the price of Options by going to: ThinkorSwim Tutorial - The Options' Theoretical Price and the Expected Price Calculator.

If you have found this article helpful remember to:

- Rate it up

- Share it

- Leave a comment or question

- Add you as my follower to get my next Hubs

Not yet an HubPages Member, sign up from here: