There are many pricing models to calculate the theoretical value of an option. These values do not always match to the actual market value but the are used by professional traders as a price guess.
The most prominent is the Black-Scholes model (developed by Fisher Black and Myron Scholes in 1973). The model itself is extremely complex. It breaks the price into several components:
- Delta – change in the option price versus a change in the underlying security. Out-the-money option has lover delta then at-the money.
- Gamma – the rate of change Delta. Gamma is a measure of the calculated delta’s sensitivity to small changes in share price.
- Vega – percentage of the change in volatility. It shows how sensitive is the price to the changes in the volatility
- Theta – mathematical expression how much value is lost each day. The closer to expiration the less time value of the option.
Since 1973, the Black-Scholes Pricing Model has been the subject of much attention. Many financial scholars have expanded upon the original work.