2. The Concept of "Fair Prices"

What's the "fair price" of an option or options spread at any point in time? The fair, or theoretical, price is a function of several variables: time to expiration, price of the underlying futures contract, strike price(s) of the option(s), and implied volatility.

The "wild card" is implied volatility since a trader who anticipates implied volatility will remain unchanged will arrive at a value that's lower than a trader who expects implied volatility will rise.

After inputting his assumption for implied volatility into an options pricing model or software program like OptionVue5, each trader can see how the values computed by the program compare to the actual prices of the options. This tells him whether the options are overvalued, undervalued, or at fair value.

It's important to understand this process because it underscores the fact that different traders will arrive at different fair values. And this, of course, is what leads to trading opportunities. The trader who perceives an option or spread is less than fair value will want to buy it. And if the current price is greater than fair value, he will want to sell it because it would be overvalued.

While floor traders make such decisions using a very short term trade horizon, off-floor traders need to take a longer perspective. That's where viewing volatility charts is important. They give a trader visual information showing where volatility has been so it's easier to forecast where it may be in 30 days.

Each of my recommended positions show projected outcomes at future dates (usually 30 days) based on a forecast of implied volatility.

"Knowledge is power and all traders can benefit by continually bolstering their knowledge base. I hope to contribute in that regard."  Paul Forchione