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Chapter 3
The InTellIgenT 
InvesTor’s guIde To 
opTIon prIcIng
By the end of this chapter, you should understand how changes in the follow-
ing Black-Scholes-Merton model (BSM) drivers affect the price of an option:
1. Moneyness
2. Forward volatility
3. Time to expiration
4. Interest rates and dividend yields
Y ou will also learn about the three measures of volatility—forward, im-
plied, and statistical. Y ou will also understand what drivers affect option 
prices the most and how simultaneous changes to more than one variable 
may work for or against an option investment position.
In this chapter and throughout this book in general, we will not try to 
figure out a precise value for any options but just learn to realize when an op-
tion is clearly too expensive or too cheap vis-à-vis our rational expectations 
for a fair value of the underlying stock. As such, we will discuss pricing in 
general terms; for example, “This option will be much more expensive than 
that one. ” This generality frees us from the computational difficulties that 
come about when one tries to calculate too precise a price for a given op-
tion. The BSM is designed to give a precise answer, but for investing, simply 
knowing that the price of some security is significantly different from what 
it should be is enough to give one an investing edge.