Calculate an Option’s Fair Value With This Free Tool
Today, I’m picking up where we left off on Friday: with a promise to show you how to calculate an option’s fair value, and to share a preview of the top ETFs to own through November.
Based on what we see in our mailbag, most of you are brand-new to the world of options.
So, over the past few weeks I’ve brought things back to basics…
I’ve focused on how to place option orders over the past few weeks. This may not seem like the most exciting aspect of options trading, but it is also the one that can separate an effective option trader from a struggling one.
I’ve mentioned using limit orders, and suggested setting the limit price between the bid and ask price. That’s a useful shortcut for getting a quick trade execution.
But, if you really want to make sure you’re paying the best price, you can also set the limit near the option’s fair value. Figuring that out will require just a little more effort.
The fair value of an option is difficult to calculate. It’s determined by factors including the stock’s price, any dividends the company pays, current interest rates, the time to expiration for the option, the expected volatility of the stock prior to expiration, and the relationship between these factors.
Market professionals put those variables into a formula called the Black-Scholes model, which often looks something like this.
If you’re looking at this formula and are tempted to flip your desk over, take a deep breath. You don’t have to understand this formula to determine fair value. I’ll show you how in a moment.
Based on those formulas, market makers ensure that the current bid and ask prices are close to the fair value.
There’s a simple reason for that. If the bid or ask is significantly different than the fair value, large traders can immediately capture a risk-free profit.
Let’s say the formula says a call option is worth $1.00. For some reason, the current bid is $0.30, and the ask is $0.70. Using math based on the put-call parity formula, traders can immediately buy that option at $0.70 and sell it for $1.00 as the quote gets updated. The reason for that is most likely someone forgot to update a quote.
You and I will never see an opportunity like that, though.
High-frequency traders, with access to data straight from the exchange, do see quotes like that. When they do, they will execute the required trades to capture that profit in milliseconds, if not nanoseconds.
But while we can’t profit from small mispricings, we can set our limit near the fair value to maximize profits on winning trades. The gains might be just a few dollars per contract, but this can add up over a long options trading career.
So, let’s talk about a simple way to determine fair value.
Finding Fair Value Is Easier Than You Think
Let’s say an option is trading with a bid of $0.30 and the ask is $0.70. It’s reasonable to set a limit price at $0.50 — the midpoint between the bid and ask — and expect it to be filled. It’s likely the option’s fair value is around $0.50.
But if the option’s fair value is $0.60, a sell order at $0.55 is equally likely to be filled. This is worth $5 per contract. Over time, and based on how many contracts you trade, that can add up to hundreds, if not thousands of dollars a year.
Fortunately, we don’t need to use the complex formulas to find fair value. We can use a simple, free, online calculator.
Here’s what it looks like…
(Click here to view larger image.)
To use the calculator, enter the symbol of the stock or ETF and press <GO>. In this example, we’ll use the SPDR S&P 500 ETF (SPY) — the only ticker I trade in my One Trade advisory.
That pulls up this data:
(Click here to view larger image.)
The calculator will show the fair value of an at-the-money option for the previous day’s closing price (along with all the “Greeks” of option trading, which we’ll look to cover another day).
You’ll want to update the Strike field for whatever strike you’re looking to trade that moment, and update the Price field to the latest price of SPY.
You can also update the volatility. An option’s current volatility can be found on your broker’s website or in Yahoo! Finance. Click calculate and it will return a real-time value of your option. This is where you should set your limit orders for ideal execution.
This might only add a few dollars to winning trades, but small changes add up over time.
November’s Top ETFs
Now, if you’re looking for some ETFs to try this new tool out on, allow me to make a recommendation…
Last month, I began sharing trading ideas based on how I managed money in the late 2000s. It’s a simple, conservative ETF strategy with a high win rate and which prioritizes ETFs that lead the market.
My recommendations from last month, the Global X Lithium & Battery Tech ETF (LIT) and the Global X MSCI Argentina ETF (ARGT), are up 12% and 1% respectively since October 1. Clearly LIT was the winner here, as supply chain issues continued to propel industrial commodities higher nearly across the board.
We’ll dive into more about it on Monday, but the ETFs showing the most strength right now are the Invesco DB Commodity Index Tracking Fund (DBC) and iShares MSCI India ETF (INDA). This is similar to last month, when we saw strength in emerging markets and commodities.
Michael Carr, CMT, CFTe
Editor, One Trade
Chart of the Day:
Yep, We’re Talking
About Dog Coins
(Click here to view larger image.)
Did you really think we were going to get through this week without talking about the SHIB chart?
Yes indeed, the meme of the week has a chart worth talking about. And what might surprise you is I’m not about to forecast the death of SHIB and other dog coins. On the contrary, SHIB has done exactly what it needs to do to NOT crash.
I’ll be straight with you: the chart is a mess. There’s not much horizontal support/resistance to speak of in the short-term. It’s just been whipping around, fueled by greed and countless $100 positions on new Coinbase accounts.
Still, though… Take a look above. Last night, SHIB broke out of a descending triangle pattern and put in a higher high.
It has shaky, but arguable support by connecting the peak in the high 50s from Wednesday — and the rejection and retest — to the lows from yesterday. And as I write this, it’s gently testing the 50-hour EMA. It’s consolidating the insane move from earlier this week.
I really don’t think SHIB is done. I actually believe it will make new highs in the next 3-6 months. And that’s why I’m still holding something like 5 million SHIB. (I took back my initial capital after it 3x’d.)
Listen, I’m not recommending anyone put anything more than a grubstake into this thing. Something you’d laugh about if this asset goes to zero.
At the same time, SHIB actually has a use case and ecosystem surrounding it. It has a functioning decentralized exchange and an NFT marketplace. And the developers are apparently looking into a way to reduce the supply (currently just below 550 trillion), which would naturally be bullish for the price.
That, in my view, actually puts it well ahead of what DOGE and other meme coins are doing — which is not very much at all.
SHIB has surprised us before, and it may well surprise us once again. Just… please tread lightly.
Managing Editor, True Options Masters