Fair Value and Theoretical Value

Fair value is defined as the actual worth of an option-buying or selling it at this price leaves little to no profit opportunity. This value is important to know because it can be used to ascertain whether an option is expensive or reasonably priced. Option traders use fair value as a reference, and profit by purchasing options for less than their fair value or selling them for more than their fair value. At expiration, it is very easy to determine an option's fair value. Before expiration the fair value of an option is an estimate and is termed "theoretical" value. This value is generated by an option pricing model in OptionStation.

At expiration, there is a very straightforward method of determining the fair value of an option. For a call option at expiration, if the underlying asset is trading at a price that is greater than the strike price, the fair value is equal to the difference between the price of the underlying asset and the option's strike price. For a put option at expiration, if the underlying asset is trading at a price which is less than the strike price, the fair value is equal to the difference between the option's strike price and the underlying asset.

Prior to expiration, the fair or theoretical value of an option is considerably more difficult to determine. What you may consider a reasonable theoretical value, another trader may find unreasonable. This is because one cannot predict with 100% certainty the price of the underlying asset at option expiration. As explained above, knowing the asset's value at expiration is the only way can one truly determine an option's fair value. Consequently, prior to an option's expiration, one can expect disagreement about its fair value. This disagreement is healthy for the market and it is this difference of opinion that creates both buyers and sellers.