This formula is work only for ATM of OTM money option. The only way to win is by analyzing the historical data. This is how option market makers make money in options - by exploiting the difference between their traded price and the theoretical price of the option. So how can this price difference(given above) be exploited? What should be the position for PUT. You mentioned "by exploiting the difference between their traded price and the theoretical price of the option". Market has gone bullish and there is 19 days to expiry. This will assist in building a strategy.Į.g. Also, volatility forecasting in itself is a tough subject to master. This is not really a good strategy for the average retail trader as the relatively higher brokerage charges will eat up a lot of the potential profits. The idea is that you've priced the option using a specific volatility value, which is assumed to be the volatility that the underlying will experience from the trade date until the expiration date. Have to note how this can be integrated with my existing setup.Įxploiting the difference between the theoretical price and the actual price of an option requires constant hedging of the option with the underlying instrument and becomes a bet on volatility. If the time ratio is just days,then how to calculate.Īlso, formula only works if forward is flat, ie divs = R The ratio includes the days - so if there are 30 days to expiration then "time ratio" is 30/365. Hi Manish, can you explain further please? What values did you use? You can use a volatility calculator to calculate the historical volatility or use your own view of what you think the volatility will be from trade date until the expiration date. How do I explain this, please? Also, whats the key assumption of this simplified method? I got a 28.81 market price when I use the BS model (from your spreadsheet) and I get 22.62 when I use the simplified pricing method. The quick pricer here is only an estimate btw. What were the other parameters that you used in your BS model inputs? Remember, this only works for ATM options, where ATM would be assumed to be the forward price of the underlying given the expiration date of the option not the actual spot price. Let's take this formula and compare it to the Black and Scholes formula used in my option pricing spreadsheet. Option Theoretical (approx) = 2.07 How Accurate is this Formula? The underlying volatility is 23% and the current stock price is $45. So, for a 6 month option take the square root of 0.50 (half a year).įor example: calculate the price of an ATM option (call and put) that has 3 months until expiration. Time ratio is the time in years that option has until expiration. Price = (0.4 * Volatility * Square Root(Time Ratio)) * Base Price If you've no time for Black and Scholes and need a quick estimate for an at-the-money call or put option, here is a simple formula.
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