Tools for Canadian option traders.

The options calculator is available at www.m-x.ca. Once at the main page, click Options Calculator under Trading Tools at the left side of the page.

This tool allows you to calculate the theoretical fair value (TFV) of a particular option contract. Or conversely, the volatility being implied by the current option price. Either approach can assist a trader in understanding which strategy makes the most sense.

For example, suppose that you were bullish on a particular stock. Within the option pricing formula all factors except volatility, are known. Volatility being the lone estimate.

In the end, whether an option is overpriced or under-priced (i.e. its TFV is greater or less than the options actual price) comes down to whether you believe the market is overstating or understating future volatility for the underlying stock. In either case, you must have some estimate to plug into the formula.

Suppose then, that you believe the best estimate for volatility is the underlying stock’s most recent 90 day historical volatility. If so, you would plug the annualized version of that number into the option calculator along with the known factors; stock price, strike price, time to expiration, risk free rate and dividends payable.

Annualized volatility requires a bit more discussion. Remember, the option calculator requires an annual volatility input. The 90 day historical volatility calculation only account for 25% of a year. Before inputting this data, we have to annualize the number. That’s accomplished by multiplying the 90 day volatility by the square root of time. In this case, time is the square root of 360 days divided by 90 days.

Having input a volatility assumption you then click calculate. The option calculator will provide a theoretical fair value (TFV). Which leads to the next question; what does that mean to you?

Well, if the TFV is greater than the current price of the option, you have concluded that the option’s current price is cheap… i.e. trading for less than its fair value. Since you were looking to implement a bullish strategy, you would in this case, buy the undervalued calls.

If on the other hand, you went through the same exercise and discovered that the option’s current price was greater than its TFV, you have by definition, concluded that the options are overvalued. You would be better off employing an option writing strategy. Since you are bullish on the underlying stock, you would look at covered call writing or naked put writing rather than a call buying strategy. Covered call writing and naked put writing are both bullish strategies that involved writing overvalued options rather than buying undervalued options.