OPTION PRICING MODELS

Current price of the underlying asset(e.g call option option price increases as the stock price increase) Strike price of the option ( fixed for the lifetime of the option higher the strike price higher the option price) Time to expiration of the option (longer the expiration time-higher will be value of option) Expected stock price volatility (greater the volatility higher will be the value) Risk free interest rate (higher the short term risk free interest rate, greater the price of call option) Anticipated cash payments on the stock (decreases the price of a call option ; increases the price of the put option)

FACTOR

SYMBOLS

Effect of increase of factor on Call Price

Effect of increase of factor on Put Price

Current Price of stock Strike price Time to expiration of option Price volatility of stock Interest rate (short term)

(S) (K) (t) ( ) (r)

Anticipated cash payments

(c)

Decrease

Increase

Developed by Fisher Black and Myron Scholes Designed to price European options on non-dividend paying stocks This model allows for an analytical solution

Stock prices follow random walks. (B-S assumption) (proportional changes in the stock price in the short period is normally distributed) A variable takes only a positive position in a log normal distribution. A log normal distribution is skewed with the mean, median and mode all different. The price relative can never be negative and hence the price relatives cannot be normally distributed

Stock price behavior correspond to the log normal distribution. It assumes that and are constant. There are no transaction costs or taxes. All securities/stocks are perfectly divisible. No dividend payments on stock during the life of the option. There are no riskless arbitrage opportunities. Stock trading is continuous. Investors can borrow or lend at the same risk free rate of interest. The short-term risk free interest rate r is constant.

Construction of a hypothetical risk free portfolio consisting of long call options and short positions in the underlying stock on which the investor earns the riskless return. Short period stock price perfectly correlates with option price, and the price of a put option is perfectly negatively correlated with the price of the stock. With an appropriate portfolio of the stock and option, profit and loss from the stock position will offset the profit and gain from the option position the overall value of the portfolio at the end of the short period of time is known with certainty.

Black and Scholes drive the following equations for pricing European call options on non-dividend paying stocks:

C = P= Where d1 = d2=

Advocated by Cox, Ross and Rubinstein in 1979 Technique of pricing a stock option through constructing a binomial tree. This is a tree which represents different possible paths that might be followed by the stock price over the life of the option. This model does not permit an analytical solution rather solves the problem numerically.

There are no market frictions (no transaction costs, no bid/ask spreads, no margin requirements, no restriction on short sales, no taxes). Market participants entail no counter party risk (no risk of default by the other party). Markets are competitive. (market participants act as price takers and not the makers). There are no arbitrage opportunities. There is no interest rate uncertainty.

A one step binomial model Two-step binomial trees

OPTIONS CONTRACTS 1. One party (the buyer) is not obligated to transact the contract, at a later date, only the other party (the seller) is under the obligation to perform the option contract and only if the buyer desires so.
2. One party (buyer) has to pay in cash the option price (premium) to the other party ( seller) and this is not returned to the buyer whether he insists for actual performance of the contract or not.

FUTURE CONTRACTS 1. Both the parties, buyers and sellers, are under obligation to perform the contract.

2. No cash is transferred to either party at the time of the formation of the contract.

OPTIONS CONTRACTS 3.The most that the buyer of an option can lose is the option price against which he possesses all the potential benefits. The maximum profit that the seller if the option contract may realize is the options price. This is to offset against substantial down side risk.
4. They are brought into existence by being traded. There is no limit to the number of option contracts that can be in existence at any time.

FUTURE CONTRACTS 3. The buyer of the contract realizes the gains in cash when the price of the futures contract increases and incurs losses in case of fall in the prices. This position is opposite in the case of the seller of the futures contract
4. There is a process of closing out position which close contracts to cease to exit, hence diminishing the total number in comparison to options.

Option spreads are the way to trade/speculate on relative price changes A spread trading strategy can be constructed by taking a position in two or more options of the same type , that is combining two or more calls or two or more puts. DIAGRAM Vertical, Horizontal and Diagonal

Vertical spreads involves simultaneous buying and selling of options on the same underlying instrument for the same expiry month but with different exercise prices. Vertical bull spread an investor purchases a call option on a stock with certain strike price and selling a call option on the same stock with a higher strike price. Both the options have the same expiration date.

Vertical spreads involves simultaneous buying and selling of options on the same underlying instrument for the same expiry month but with different exercise prices. Vertical bull spread an investor purchases a call option on a stock with certain strike price and selling a call option on the same stock with a higher strike price. Both the options have the same expiration date.

BULLISH CALL OPTION SPREADS It is created by simultaneously buying and selling call options with the same expiration date. A bullish call option spread is created by purchasing a call option with a low strike price and selling a call option with a higher strike price both with the same expiration date. BULLISH PUT VERTICAL OPTION SPREADS buying a put option with a low strike price and selling a put option at a higher strike price, both having the same expiration date. BEARISH VERTICAL OPTION SPREADS the investor purchases the option with a high strike price and sells at a lower strike price, both having the same expiration period. BEARISH VERTI CAL PUT OPTION SPREAD: the investor creates put spread by purchasing a put with a high strike price and sells a put with a low strike price

.A butterfly spread is a particular position in options with three different strike prices. The investor purchases a call option with a relatively low strike price, X1 and high strike price, X3 and selling two call options with a strike price, X2, halfway between X1 and X3. Usually X2 is close to the current stock price.

A horizontal spread is created by using the options with different maturities (expiration dates) but with the same strike price. It is called horizontal spreads because the various expiry months are shown horizontally in the financial press publications. A horizontal spread is created by selling an option with a relatively short period to expiration and buying an option the same type with longer period to expiration. The longer the maturity of an option the more expensive it is.

Diagonal spreads include both types of vertical and horizontal spreads.

A combination is an option trading strategy that involves by taking a position in both call and put on the same asset. This is also used as volatility trading which means taking position on changes in market expectations of price volatility. The main strategies are straddles, strangles, strips and straps.

It involves simultaneous buying a call and put with the same strike price and expiration date. It can be divided into categories: Long straddle and short straddle. Long straddle buying an equal number of calls and puts with the same stock, at the same strike price and for the same expiration date. Short straddle simultaneous sale of a call and a put on the same stock at the same exercise price and for the same exercise date.

STRIP refers to a long position with one call and two put options with the same strike price and the expiration date.
STRAP consists of a long position with two calls and one put options with the same strike price and the same expiration date.

The investor buys a put and a call with the same expiration date but with different strike prices. Long Strangle : When a strangle position is purchased. (Bottom vertical combination) Short Strangle : if the strangle position is sold (Top vertical combinations)