Option Pricing Theory is a tool used by traders to estimate the value of an options contract. It assigns a premium, or price, to the option based on its estimated probability of finishing in-the-money (ITM) at expiration. This provides an evaluation of what would be considered fair value for that particular option and allows traders to incorporate it into their strategies accordingly.The theory uses various factors such as time remaining until expiration, underlying stock volatility and current interest rates when calculating this probability and assigning a premium price to each option contract. The most commonly used model for estimating these probabilities is called Black Scholes Model which takes into account all these variables in order calculate the expected return from trading any given options contract over its lifetime before expiry date arrives.In conclusion, Option Pricing Theory helps traders evaluate potential returns from investing in certain types of derivatives contracts like Options Contracts by providing them with estimates about how likely they are going finish In The Money (ITM). This knowledge can then be incorporated into their strategies so that they can make more informed decisions when placing trades with more confidence knowing exactly what kind return they could expect if everything goes according plan.
