50  •   The Intelligent Option Investor
In terms of how this chapter fits in with the goal of being an 
intelligent option investor, it is in this chapter that we start overlaying 
the range of exposure introduced in Chapter 1 with the implied stock 
price range given by the BSM cone that was introduced in Chapter 2. 
This perspective will allow us to get a sense of how expensive it will 
be to gain exposure to a given range or, conversely, to see how much 
we are likely to be able to generate in revenue by accepting exposure 
to that range. Understanding the value of a given range of exposure as 
perceived by the marketplace will allow us to determine what option 
strategy will be best to use after we determine our own intelligent 
valuation range for a stock.
Jargon introduced in this chapter is as follows:
Strike–stock price ratio Volatility (Vol) 
Time value  Forward volatility
Intrinsic value  Implied volatility
Tenor   Statistical volatility
Time decay  Historical volatility
How Option Prices are Determined
In Chapter 1, we saw what options looked like from the perspective of 
ranges of exposure. One of the takeaways of that chapter was how flexible 
options are in comparison with stocks. Thinking about it a moment, it is 
clear that the flexibility of options must be a valuable thing. What would 
it be worth to you to only gain upside to a stock without having to worry 
about losing capital as a result of a stock price decline? 
The BSM, the principles of which we discussed in detail in Chapter 2, 
was intended to answer this question precisely—“What is the fair value of 
an option?” Let us think about option prices in the same sort of probabilis-
tic sense that we now know the BSM is using.
First, let’s assume that we want to gain exposure to the upside poten-
tial of a $50 stock by buying a call option with a strike price of $70 and a 
time to expiration of 365 days. Here is the risk-return profile of this option 
position merged with the image of the BSM cone: