Sometimes referred to as a fair or hypothetical value, a theoretical value is the estimated price of an option. The options pricing may have to do with buying, selling, or a combination of the two. In most cases, this value is calculated using some specific type of mathematical equation. There are several such models in use today.
One of the most popular models for estimating the price of options is know as the Black-Scholes Option Pricing Model. First introduced in 1973, this formula was the brainchild of Fischer Black and Myron Scholes. Considered to be highly accurate, the concept quickly gained attention and remains one of the most workable of all formulas in common use today.
Calculating the theoretical value is helpful to investors in a couple of ways. First, the determination of a hypothetical value for the option or options, given specific market conditions, can provide insight into whether the purchase or sale of the security is a good idea. The theoretical value, of course, relies on the quality of the assumptions made regarding market performance in general and the performance of the option in particular.
Second, the calculation of a theoretical value allows the investor to engage in projecting performance based on several different scenarios. The Black-Scholes approach, as well as other mathematically based formulas used to project theoretical value, allows for the inclusion of different figures. By running several projections, the investor can identify the most likely future situation that will apply, while still being prepared for what would happen if one or more factors turn out to be different.
Theoretical value is one of the most basic tools used in trading today. By comparing the estimated value to the current market price of an option, it is possible to determine if the purchase or sale is likely to generate a return at some future point. Brokers and investors commonly employ this concept before making any type of investment decision.