Options Pricing: Distinguishing Between Option Premiums and Theoretical Value

It's important to differentiate between an option premium and its theoretical value. As discussed previously, the option premium is the price the option buyer pays in order to have the right granted by the option – and the money the seller receives in exchange for writing the option.

The theoretical value (or fair value) of an option, on the other hand, is the estimated value of an option derived from a mathematical model, such as the Black-Scholes model. It's what an option should currently be worth using all the known inputs, such as the underlying price, strike price and days until expiration. These factors often change during an option's lifetime, and some fluctuate in value on a continuing basis throughout any trading session.

A pricing model creates theoretical values, but they're just that – theoretical. Specific values for each factor can be used to predict an option contract's theoretical value at a given point in the future. When options are first listed on a stock, for example, the market makers don't know what sort of implied volatility to use, so they make educated guesses (theoretical values). The implied volatility then changes based upon the supply and demand for the options.

The next few chapters in this tutorial cover some of the different types of models that investors use for option pricing.