While trading in options market, the option traders often take advantage of the arbitrage opportunities available in the market. In this way, they are able to make small profits buy going long on underpriced options and going short on overpriced options.  For example, if call options are overpriced in comparison to put options, then the option trader will go short a naked call and go long a synthetic call.

However, how does a trader determine whether the option is overpriced or underpriced?

In general, the Black-Scholes option pricing model is the most commonly used model to price options. The price thus calculated is called the theoretical price of the option. One key variable in this model is the option’s volatility.

Traders will use the historical volatility to calculate the theoretical price of the option. This theoretical price when compared to the actual market value of the option tells us whether the option is overpriced or underpriced. The volatility as represented by the market price is known as implied volatility. The higher the implied volatility the higher will be the value of the option.

This is the simplest way to take a rough guess at whether the option is over or underpriced. However, this comparison may not always be correct as there could be other factors influencing the prices.