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Option Pricing (FD)

An option is a contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price on or before a specified date. There are two main types of options: calls, which give the right to buy, and puts, which give the right to sell. Option pricing is affected by factors like implied volatility, the strike price, time until expiration, and the underlying asset price. Implied volatility refers to the expected volatility of the underlying asset's price as estimated from real-time option pricing.

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Shrestha Varshney
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124 views3 pages

Option Pricing (FD)

An option is a contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price on or before a specified date. There are two main types of options: calls, which give the right to buy, and puts, which give the right to sell. Option pricing is affected by factors like implied volatility, the strike price, time until expiration, and the underlying asset price. Implied volatility refers to the expected volatility of the underlying asset's price as estimated from real-time option pricing.

Uploaded by

Shrestha Varshney
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Unit- 3

What is an Option?
A formal definition of an option states that it is a type of contract between two parties
that provides one party the right, but not the obligation, to buy or sell the underlying
asset at a predetermined price before or at expiration day. There are two major types of
options: calls and puts.

 Call is an option contract that gives you the right, but not the obligation, to buy the
underlying asset at a predetermined price before or at expiration day.
 Put is an option contract that gives you the right, but not the obligation, to sell the
underlying asset at a predetermined price before or at expiration day.

Options may also be classified according to their exercise time:

 European style options may be exercised only at the expiration date.


 American style options can be exercised anytime between purchase and expiration
date.

The above-mentioned classification of options is extremely important because choosing


between European-style or American-style options will affect our choice for the option
pricing model.

PRICING OPTIONS

The most important thing an investor needs to understand is how options are
priced and some of the factors that affect them including implied volatility. Option
pricing is the amount per share at which an option is traded. Although the option
holder is not obligated to exercise the option, the seller must buy or sell the
underlying instrument if the option is exercised.

Learn more about options, and how volatility and implied volatility work in this
market.

KEY TAKEAWAYS

 Option pricing, the amount per share at which an option is traded, is


affected by a number of factors including implied volatility.
 Implied volatility is the real-time estimation of an asset’s price as it trades.
 When options markets experience a downtrend, implied volatility generally
increases.
 Implied volatility falls when the options market shows an upward trend.
 Higher implied volatility means a greater option price movement can be
expected.

Options are versatile and can be used in a multitude of ways. While some traders
use options purely for speculative purposes, other investors, such as those in
hedge funds, often utilize options to limit risks attached to holding assets.
An option's price, also referred to as the premium, is priced per share The seller
is paid the premium, giving the buyer the right granted by the option. The buyer
pays the seller the premium so he has the option to either exercise the option or
allow it to expire worthless. The buyer still pays the premium even if the option is
not exercised, so the seller gets to keep the premium either way.

Consider this simple example. A buyer might pay a seller for the right to
purchase 100 shares of Company X's stock at a strike price of $60 on or before
May 19. If the position becomes profitable, the buyer will decide to exercise the
option. If, on the other hand, it does not become profitable, the buyer will let the
option expire, and the seller gets to keep the premium. 

There are two facets to the option premium: The option's intrinsic value and time


value. The intrinsic value is the difference between the underlying asset's price
and the strike price. The latter is the in-the-money portion of the option's
premium. The intrinsic value of a call option is equal to the underlying price
minus the strike price. A put option's intrinsic value, on the other hand, is the
strike price minus the underlying price. The time value, though, is the part of the
premium attributable to the time left until the option contract expires. The time
value is equal to the premium minus its intrinsic value.
There are a number of factors that affect options pricing including volatility, which
we'll look at below.

 
Other factors that affect options pricing include the underlying price, strike price,
time until expiration, interest rates, and dividends. 
Implied Volatility
Volatility, in relation to the options market, refers to fluctuation in the market price
of the underlying asset. It is a metric for the speed and amount of movement for
underlying asset prices.
STRIKE PRICE

the strike price (or exercise price) of an option is the fixed price at which the owner of
the option can buy (in the case of a call), or sell (in the case of a put), the
underlying security or commodity. The strike price may be set by reference to the spot
price (market price) of the underlying security or commodity on the day an option is
taken out, or it may be fixed at a discount or at a premium.

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