Options Pricing & Valuation models

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What is an Option?

• An option is a financial derivative which means it derives its value from another financial security. An option writer sells the option to an option buyer. The agreed-on price between the two parties is called the strike price and there is always a specified date which signifies when the option expires. You can exercise your right to buy or sell the option. This means you do not have to buy or sell if you do not want to. If you hold an American option, then you can exercise your right on the option any time before the expiration date. If you hold a European option, you can only exercise your right on the expiration date. They are mainly used to speculate or hedge any of your current holdings.

Call Option vs. Put Option

• A call option allows the buyer to buy the underlying security at the strike price. In this situation, the buyer would want the price of the stock to be higher than the strike price because the buyer pays the agreed upon strike price. This allows the buyer to sell the stock at the current market price and make a profit from it. If you write a call option, you believe that the price of the stock will either drop or stay the same. The profit that a writer can make from selling a call option is the difference between the price of the stock and the strike price, the premium.

• A put option allows the buyer of the option to sell the underlying security at the strike price. A buyer of a put option wants the price of the security to drop because the buyer can sell the security at a strike price that is higher than the market price. However, a put option writer wants the price of the security to raise above the strike price because the buyer would have to sell it to them at a lower price.

Option Pricing Models

• Two ways to price options are the Black-Scholes model and the Binomial model. The Black-Scholes model is used to find to find a call price by using the current stock price, strike price, the volatility, risk free interest rate, and the time until the option expires. The Binomial model uses a tree of stock prices that is broken down into intervals. This tree represents the potential value of a stock from the present date and until the expiration. From this, one can find the value of the option with the strike price, volatility, risk free interest rate and the stock price at expiration date.

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How to Trade Options

Option Pricing Models

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