What is the difference between theoretical option value and actual value?
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The theoretical value of an option or strategy is simply the result of a model. This has a certain number of inputs such as the time to expiry or the expected volatility of the underlying product. These inputs are either public information or the opinion of the specific trader. Theoretical values are used as a guide for trading in the sense that the values are only accurate if the underlying assumptions and inputs to the model are all accurate.
The actual value of an option is the prevailing value in the market. It is the fair value of the option or strategy independent of any one trader’s opinion.
To understand the difference, simply think of an object you own. You will have your own perception of its value given its age, appearance, the value of similar objects etc. These are inputs in your own ‘model’ of the theoretical value of the object. The actual value of the object however will be the value at which objects identical to this are trading in a market. Clearly this may differ from your own theoretical value. And so over time you must decide whether your theoretical value needs to be adjusted to reflect the actual value.
When trading any derivatives, it is normal to use our theoretical value as a guide and to see the actual value as the true current value. Typically, traders ‘re-mark’ their theoretical values to match the actual values; they may do this daily or weekly or monthly, depending on circumstances.
In Volcube, you must adjust your theoretical values mentally to account for any discrepancy between the prevailing actual values and your baseline theoretical values. This is done using the vega of the strategy or option and by comparing the theoretical implied volatiliy to the actual impied volatility. You can also practise updating your theoretical values during the game using the Volatility Manager in some editions.
Volcube is an options education technology company, used by option traders around the world to practise and learn option trading techniques.