How Are Options Priced?

Widening investment horizons and growing popularity is making more investors inclined towards the risky yet lucrative options'

. However, having an in-depth understanding on various aspects involving options trading including the most crucial element of option pricing assures investors reap maximum profit out of their investments.

More about Options:

It is a contract to deal in certain underlying assets.

It is merely a right and not any obligation to deal with the said asset.

The holder of the contract can buy or sell the asset at a pre determined price, irrespective of the actual price prevailing on the day of executing the contract.

It has an expiration date and holder can trade on any till the expiration.

Buyers of options are holders' and sellers are writers'.

Value of option depends on the price behavior of the underlying asset

Understanding option pricing or value of an option is crucial to capture probable price movement of underlying asset and reap maximum profits. Let's look into main elements that drive price of an option.

Market value of underlying asset The rise in the asset price spurs the value of call option and decreases the put option price and vice versa.

Strike Price It plays a key role in determining the intrinsic value of option. in-the-money' options, which are as a result of higher strike price compared to underlying asset price, have greater value.

Time till expiry As expiry date approaches, option value drastically decreases especially for at-the-money' options.

Among the various models to calculate option pricing, the most popular ones are the Black-Scholes model and the Binomial model. Black-Scholes model arrives at a theoretical call price by considering the asset price, strike price, time to expiration, volatility and short term interest rate. This model is widely used as it allows arriving at very large number of option prices in quick time. Binomial model focuses on time to expiry and breaks it into many time intervals thus forming a tree of various assumed asset prices. This model is mostly used for American options.

Given the complexity of option pricing, various models, it is prudent to have a thorough understanding of various aspects of options before trading in them.

by: kellyprice1225

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