Black & Sholes formula calculates the fair value of the option and helps you to find out if call and put options are underpriced or overpriced. There are 5 factors that impact the calculation of the fair valuation of an optionâ€¦

First is market price of the underlying stock. In case of call options, higher market prices increase the value of the options. The reverse is true in case of put options.

Second is strike price of the option. In case of a call option, a higher strike price reduces the fair value of the option. In case of a put option, the reverse is true.

Third is volatility of the stock price. Higher volatility higher is the value of the option. That is because; if the volatility is in your favour then the option is more valuable and if the volatility is against you then you just lost the premium. Higher volatility is positive for call options and for put options.

Fourth is time to expiry of the option. Greater the time to expiry, more the probability of that you will make money on the option. Longer time to expiry is positive for call options and also for put options.

Fifth is the risk free interest in the market. Why are interest rates relevant? Options strikes pertain to a future date and hence time value becomes material. Higher interest rates mean lower present value of the strike price and therefore higher option value in case of call options. The reverse is true in case of put options.

These are the 5 variables that are used to calculate the fair value of the option and then to decide whether the option is underpriced or overpriced.

Arusha Rayanswered.Black & Sholes formula calculates the fair value of the option and helps you to find out if call and put options are underpriced or overpriced. There are 5 factors that impact the calculation of the fair valuation of an optionâ€¦

First is market price of the underlying stock. In case of call options, higher market prices increase the value of the options. The reverse is true in case of put options.

Second is strike price of the option. In case of a call option, a higher strike price reduces the fair value of the option. In case of a put option, the reverse is true.

Third is volatility of the stock price. Higher volatility higher is the value of the option. That is because; if the volatility is in your favour then the option is more valuable and if the volatility is against you then you just lost the premium. Higher volatility is positive for call options and for put options.

Fourth is time to expiry of the option. Greater the time to expiry, more the probability of that you will make money on the option. Longer time to expiry is positive for call options and also for put options.

Fifth is the risk free interest in the market. Why are interest rates relevant? Options strikes pertain to a future date and hence time value becomes material. Higher interest rates mean lower present value of the strike price and therefore higher option value in case of call options. The reverse is true in case of put options.