When I Trade Options, Am I Overpaying?

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Is there a way that I can decide whether the premium I am paying to buy an option is more than I should or that the option is trading at a premium lower than it should be? -- S.P.

Options pricing is a highly complex concept that would require more than just a short article to fully and correctly cover. However, I will guide you in several ways that should help you judge if the premium paid on an option is a reasonable price.

(To learn more about options, check out "Options: Getting Started.")

Options are priced according to a pricing formula. The most famous one is known as The Black-Scholes model, named for Fisher Black and Myron Scholes. There are some subjective and some objective variables on which options pricing is dependent. Black-Scholes requires a series of inputs that include current price, strike price , option type (put or call ), expiration type (American or European), expiration date , interest rates, dividends and volatility .

Throwing Black-Scholes aside, with the exception of one variable -- volatility -- may make S.P.'s question less thorny to address.

Implied Volatility

Simply put, the higher a stock's volatility, the greater the option's price (no matter if it is a put or a call). Implied volatility is the volatility implicit in an options price for an individual stock or option (see "Understanding the Four Measures of Volatility"). Unless you have a Black-Scholes pricing program, you will have to obtain an option's implied volatility from a service such as Bloomberg or from a Web site like IVolatilty.com.