CandleFocus Glossary Editor
Option Pricing Theory is a mathematical model used to calculate the price of an option contract. It is widely used by financial practitioners and scholars in investments, options markets, and corporate finance. It is based on advanced principles of probability and statistics, which involve computing the chance of an option being exercised, or at least being in-the-money (ITM) at expiration. Thus, by making use of the information available on the underlying asset price, time to maturity, interest rates, and market volatility, one can endeavor to predict the expected market behavior regarding an option.
The most widely used model for calculating the value of an option is known as the Black-Scholes Model. This model pricing model is based mainly on the assumption that the underlying asset price movements follow a lognormal distribution and that the underlying asset does not pay any dividends. The model (along with the binomial tree and Monte-Carlo simulation methods) is able to calculate a price for an option, given certain assumptions and constraints.
The values derived from the model depend heavily on the assumed volatility of the underlying asset and its expected price movements. Thus, the implied volatility plays a huge role in the pricing of the option contract, since it is the most significant determinant of its value. Generally speaking, the higher the implied volatility, the higher the value of the option. Increasing the maturity of the option contract will have a similar effect, since option contracts tend to increase in value when they are held for longer periods of time.
Option pricing theory is a powerful tool for predicting the value of an option contract under different market conditions. It employs complex mathematical equations, which allow practitioners and researchers to accurately assess the probability of an option being exercised or being in-the-money at expiration. The Black-Scholes Model is the most common and prevalent model used, along with the binomial tree and Monte-Carlo simulation methods. However, implied volatility, the expected price movements of the underlying asset, and the length of the contract are all important factors in the valuation of any option contract.
The most widely used model for calculating the value of an option is known as the Black-Scholes Model. This model pricing model is based mainly on the assumption that the underlying asset price movements follow a lognormal distribution and that the underlying asset does not pay any dividends. The model (along with the binomial tree and Monte-Carlo simulation methods) is able to calculate a price for an option, given certain assumptions and constraints.
The values derived from the model depend heavily on the assumed volatility of the underlying asset and its expected price movements. Thus, the implied volatility plays a huge role in the pricing of the option contract, since it is the most significant determinant of its value. Generally speaking, the higher the implied volatility, the higher the value of the option. Increasing the maturity of the option contract will have a similar effect, since option contracts tend to increase in value when they are held for longer periods of time.
Option pricing theory is a powerful tool for predicting the value of an option contract under different market conditions. It employs complex mathematical equations, which allow practitioners and researchers to accurately assess the probability of an option being exercised or being in-the-money at expiration. The Black-Scholes Model is the most common and prevalent model used, along with the binomial tree and Monte-Carlo simulation methods. However, implied volatility, the expected price movements of the underlying asset, and the length of the contract are all important factors in the valuation of any option contract.