A Primer on Option Pricing

This is slightly on the expensive side, given that during the last five years the average volatility for GE at-the-money calls is 35, which also happens to be where the current overall market volatility (as measured by the CBOE Volatility Index , or VIX), is standing.

Using a volatility of 35, the GE December 25 call would have a theoretical value of 97 cents. For comparison, if we plug in an implied volatility of 60, often considered a panic level, the call would then be assigned a theoretical value of $1.75.

The issue of historical vs. implied volatility gets to the heart of whether a given option seems cheap or expensive when measured against the underlying asset's past trading behavior. Options trade using implied volatility, which, as indicated above, is theoretical and predictive in nature. If you decide a current price is out of whack or without precedent, you may try to profit from it.

If you want to understand more about how different components affect option prices, you can run through various scenarios using one of the many option tools available online. The Chicago Board Options Exchange's Web site is a good resource and has a calculator you can use.

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