Option Pricing Theory

Option pricing theory uses variables (stock price, exercise price, volatility, interest rate, time to expiration) to theoretically value an option. Essentially, it provides an estimation of an option’s fair value which traders incorporate into their strategies to maximize profits. Some commonly used models to value options are Black-Scholes, binomial option pricing, and Monte-Carlo simulation. These theories have wide margins for error due to deriving their values from other assets, usually the price of a company’s common stock.