Pricing options
An option buyer has the right but not the obligation to exercise on the seller. The worst that can happen to a buyer is the loss of the premium paid by him. His downside is limited to this premium, but his upside is potentially unlimited. This optionality is precious and has a value, which is expressed in terms of the option price.
Just like in other free markets, it is the supply and demand in the secondary market that drives the rice of an option. On dates prior to 31 Dec 2000, the “call option on Nifty expiring on 31 Dec 2000 with a strike of 1500” will trade at a price that purely reflects supply and demand. There is a separate order book for each option which generates its own price.
The values shown in Table 5.1 are derived from a theoretical model, namely the Black-Scholes option pricing model. If the secondary market prices deviate from these values, it would imply the presence of arbitrage opportunities, which (we might expect) would be swiftly exploited. But there is nothing innate in the market, which forces the prices in the table to come about.
There are various models, which help us get close to the true price of an option. Most of these are variants of the celebrated Black-Scholes model for pricing European options. Today most calculators and spreadsheets come with a built-in Black-Scholes options pricing formula so to price options we don’t really need to memorize the formula.
What we shall do here is discuss this model in a fairly non-technical way by focusing on the basic principles and the underlying intuition
An option buyer has the right but not the obligation to exercise on the seller. The worst that can happen to a buyer is the loss of the premium paid by him. His downside is limited to this premium, but his upside is potentially unlimited. This optionality is precious and has a value, which is expressed in terms of the option price.
Just like in other free markets, it is the supply and demand in the secondary market that drives the rice of an option. On dates prior to 31 Dec 2000, the “call option on Nifty expiring on 31 Dec 2000 with a strike of 1500” will trade at a price that purely reflects supply and demand. There is a separate order book for each option which generates its own price.
The values shown in Table 5.1 are derived from a theoretical model, namely the Black-Scholes option pricing model. If the secondary market prices deviate from these values, it would imply the presence of arbitrage opportunities, which (we might expect) would be swiftly exploited. But there is nothing innate in the market, which forces the prices in the table to come about.
There are various models, which help us get close to the true price of an option. Most of these are variants of the celebrated Black-Scholes model for pricing European options. Today most calculators and spreadsheets come with a built-in Black-Scholes options pricing formula so to price options we don’t really need to memorize the formula.
What we shall do here is discuss this model in a fairly non-technical way by focusing on the basic principles and the underlying intuition