This is an excellent question on many levels. First, most brokerage firms should supply you with some type of table that shows a theoretical price. If they don’t, it’s probably best to find a broker that is better suited for options trading. But even if they supply a table, you must understand that it does
not show whether the option is over or under priced. All it shows is the theoretical price based on an option pricing model – usually the Black-Scholes Model.
The Black-Scholes Model (as well as others) take several factors and try to determine what the fair value of that option is. The fair value is simply the price at which neither the buyer nor the sellers would generate any profits over the long run. It is a price that is fair to both parties. Of the factors considered by the model, volatility is the key factor since it is the only true unknown factor. When any model asks for the volatility, what it is really asking for is the future volatility of the stock which is something we cannot know for sure until expiration.
Just because you may have a table in front of you that shows a theoretical price of an option does not mean that you can tell if the option is over or under priced. All you can do is tell if it is over or under priced according to a theoretical model. It’s important to make this distinction because many traders falsely believe that this “fair value” number automatically shows if the option should be purchased or sold (or if the market maker has falsely inflated the price). None of these can be determined by looking at a table of theoretical numbers.
We can, however, look at the number and compare it to past history to see if it appears to be high or low relative to the past. To understand this, assume we are placing a bet on the score of a particular NFL football team in an upcoming game. A sports guru (theoretical pricing model) says that this team will score 45 points. Has the guru “falsely inflated” the score? Has he “overshot” the scoring ability of the team? We cannot say either for certain. But what we do know is that 45 points is a relatively high score for football. It is not unheard of or impossible – just relatively on the high side. This does not mean that we will win by betting the team will score fewer points. But it does mean that if we continue to make such bets (that the team will score fewer points) that we should win over the long run.
In the same way, if a pricing model says that the option is worth $4 and it is priced at $4.70 in the marketplace, has the market maker “falsely inflated” the price? Is this an option that we should definitely sell? You should now realize that neither of these statements can be known for sure. However, we
can find out if the $4.70 price is relatively high or low. To do so, we need to determine which volatility would be necessary to create the $4.70 market price. That is, we need to find the implied volatility of the option. Once we have that information, we can then figure out if that implied volatility seems to be on the high or low side of the historic volatility (the actual movements of the stock’s price).
Just be aware that any table or theoretical graph does not show whether an option is over priced or if the market maker has falsely inflated that price. All we can determine is whether that price is relatively high or low compared to the historical movements in the stock’s price.