Unit III

Option Pricing

Option pricing refers to the amount per share at which an option is traded. Options are derivative
contracts that give the holder (the "buyer") the right, but not the obligation, to buy or sell
the underlying instrument at an agreed-upon price on or before a specified future date. Although
the holder of the option is not obligated to exercise the option, the option writer (the "seller")
has an obligation to buy or sell the underlying instrument if the option is exercised.

Depending on the strategy, options trading can provide a variety of benefits, including the
security of limited risk and the advantage of leverage. Another benefit is that options can protect
or enhance your portfolio in rising, falling and neutral markets. Regardless of why you trade
options – or the strategy you use – it's important to understand how options are priced. In this
tutorial, we'll take a look at various factors that influence options pricing, as well as several
popular options-pricing models that are used to determine the theoretical value of options.

Structure of derivative market

Example of option trading

An options contract is an agreement between a buyer and seller that gives the purchaser of
the option the right to buy or sell a particular asset at a later date at an agreed upon
price. Options contracts are often used in securities, commodities, and real estate transactions.

How it works (Example):

There are several types of options contracts in financial transactions. An exchange traded option,
for example, is a standardized contract that is settled through a clearing house and is
guaranteed. These exchange traded options cover stock options, commodity options, bond and
interest rate options, index options, and futures options. Another type of option contract is an
over –the-counter option which is a trade between two private parties. This may include interest
rate options, currency exchange rate options, and swaps (i.e. trading long and
short terms interest rates).

The main features of an exchange traded option, such as a call options contract, provides a right
to buy 100 shares of a security at a given price by a set date. The options contract charges a
market-based fee (called a premium). The stock price listed in the contract is called the "strike
price. At the same time, a put options contract gives the buyer of the contract the right to sell
the stock at a strike price by a specified date. In both cases, if the buyer of the options contract
does not act by the designated date, the option expires.

For example, in a simple call options contract, a trader may expect Company XYZ's stock price to
go up to $90 in the next month. The trader sees that he can buy an options contract of Company
XYZ at $4.50 with a strike price of $75 per share. The trader must pay the cost of the option
($4.50 X 100 shares = $450). The stock price begins to rise as expected and stabilizes at
$100. Prior to the expiry date on the options contract, the trader executes the call option and
buys the 100 shares of Company XYZ at $75, the strike price on his options contract. He pays
$7,500 for the stock. The trader can then sell his new stock on the market for $10,000, making
a $2,050 profit ($2,500 minus $450 for the options contract).

What Is the Binomial Option Pricing Model?

The binomial option pricing model is an options valuation method developed in 1979.
The binomial option pricing model uses an iterative procedure, allowing for the specification of
nodes, or points in time, during the time span between the valuation date and the
option's expiration date.

The model reduces possibilities of price changes and removes the possibility for arbitrage. A
simplified example of a binomial tree might look something like this:
Another option pricing model is the Black Scholes Model, which makes assumptions about
European stock price distribution.
Basics of the Binomial Option Pricing Model
With binomial option price models, the assumptions are that there are two possible outcomes,
hence the binomial part of the model. With a pricing model, the two outcomes are a move up,
or a move down.

The major advantage to a binomial option pricing model is that they’re mathematically simple.
Yet these models can become complex in a multi-period model.

KEY TAKEAWAYS

 The binomial option pricing model values options using an iterative approach.
 With the model, there are two possible outcomes with each iteration—a move up or a
move down.
 It reduces possibilities of price changes, while removing the possibility for arbitrage.
 The model is mathematically simple.
Real World Example of Binomial Option Pricing Model
A simplified example of a binomial tree has only one step. Assume there is a stock that is priced
at $100 per share. In one month, the price of this stock will go up by $10 or go down by $10,
creating this situation:

 Stock price = $100

 Stock price in one month (up state) = $110
 Stock price in one month (down state) = $90

Next, assume there is a call option available on this stock that expires in one month and has a
strike price of $100. In the up state, this call option is worth $10, and in the down state, it is worth
$0. The binomial model can calculate what the price of the call option should be today.

For simplification purposes, assume that an investor purchases one-half share of stock and writes
or sells one call option. The total investment today is the price of half a share less the price of the
option, and the possible payoffs at the end of the month are:

 Cost today = $50 - option price

 Portfolio value (up state) = $55 - max ($110 - $100, 0) = $45
 Portfolio value (down state) = $45 - max($90 - $100, 0) = $45

The portfolio payoff is equal no matter how the stock price moves. Given this outcome, assuming
no arbitrage opportunities, an investor should earn the risk-free rate over the course of the
month. The cost today must be equal to the payoff discounted at the risk-free rate for one month.
The equation to solve is thus:
  Option price = $50 - $45 x e ^ (-risk-free rate x T), where e is the mathematical constant
2.7183.

Assuming the risk-free rate is 3% per year, and T equals 0.0833 (one divided by 12), then the
price of the call option today is $5.11.

Due to its simple and iterative structure, the binomial option pricing model presents certain
unique advantages. For example, since it provides a stream of valuations for a derivative for
each node in a span of time, it is useful for valuing derivatives such as American options – which
can be executed anytime between the purchase date and expiration date. It is also much
simpler than other pricing models such as the Black-Scholes model.

What Is the Black Scholes Model?

The Black Scholes model, also known as the Black-Scholes-Merton (BSM) model, is a model of
price variation over time of financial instruments such as stocks that can, among other things,
be used to determine the price of a European call option.

The model assumes the price of heavily traded assets follows a geometric Brownian motion
with constant drift and volatility. When applied to a stock option, the model incorporates the
constant price variation of the stock, the time value of money, the option's strike price, and the
time to the option's expiry.

KEY TAKEAWAYS

 The Black-Scholes Merton (BSM) model is a differential equation used to solve for
options prices.
 The model won the Nobel prize in economics.
 The standard BSM model is only used to price European options and does not take into
account that U.S. options could be exercised before the expiration date.
The Black-Scholes Formula Is
The Black Scholes call option formula is calculated by multiplying the stock price by the
cumulative standard normal probability distribution function. Thereafter, the net present value
(NPV) of the strike price multiplied by the cumulative standard normal distribution is subtracted
from the resulting value of the previous calculation.

In mathematical notation:

C=StN(d1)−Ke−rtN(d2)

where:C=call option price

S=current stock (or other underlying) price

K=strike price
r=risk-free interest rate

t=time to maturity

N=a normal distribution

Black-Scholes Model
What Does the Black Scholes Model Tell You?
The Black Scholes model is one of the most important concepts in modern financial theory. It
was developed in 1973 by Fischer Black, Robert Merton, and Myron Scholes and is still widely
used today. It is regarded as one of the best ways of determining fair prices of options. The
Black Scholes model requires five input variables: the strike price of an option, the current stock
price, the time to expiration, the risk-free rate, and the volatility.

The model assumes stock prices follow a lognormal distribution because asset prices cannot be
negative (they are bounded by zero). This is also known as a Gaussian distribution. Often, asset
prices are observed to have significant right skewness and some degree of kurtosis (fat tails).
This means high-risk downward moves often happen more often in the market than a normal
distribution predicts.

The assumption of lognormal underlying asset prices should thus show that implied volatilities
are similar for each strike price according to the Black-Scholes model. However, since the
market crash of 1987, implied volatilities for at the money options have been lower than those
further out of the money or far in the money. The reason for this phenomena is the market is
pricing in a greater likelihood of a high volatility move to the downside in the markets.

This has led to the presence of the volatility skew. When the implied volatilities for options with
the same expiration date are mapped out on a graph, a smile or skew shape can be seen. Thus,
the Black-Scholes model is not efficient for calculating implied volatility.

Limitations of the Black Scholes Model

As stated previously, the Black Scholes model is only used to price European options and does
not take into account that U.S. options could be exercised before the expiration date.
Moreover, the model assumes dividends and risk-free rates are constant, but this may not be
true in reality. The model also assumes volatility remains constant over the option's life, which
is not the case because volatility fluctuates with the level of supply and demand.

Moreover, the model assumes that there are no transaction costs or taxes; that the risk-free
interest rate is constant for all maturities; that short selling of securities with use of proceeds is
permitted; and that there are no risk-less arbitrage opportunities. These assumptions can lead
to prices that deviate from the real world where these factors are present.

What is an Index Option?

An index option is a financial derivative that gives the holder the right, but not the obligation, to
buy or sell the value of an underlying index, such as the Standard and Poor's (S&P) 500, at the
stated exercise price on or before the expiration date of the option. No actual stocks are bought
or sold; index options are always cash-settled, and are typically European-style options.

Basics of an Index Option

Index call and put options are simple and popular tools used by investors, traders and
speculators to profit on the general direction of an underlying index while putting very little
capital at risk. The profit potential for long index call options is unlimited, while the risk is
limited to the premium amount paid for the option, regardless of the index level at
expiration. For long index put options, the risk is also limited to the premium paid, and the
potential profit is capped at the index level, less the premium paid, as the index can never go
below zero.

Beyond potentially profiting from general index level movements, index options can be used to
diversify a portfolio when an investor is unwilling to invest directly in the index's underlying
stocks. Index options can also be used in multiple ways to hedge specific risks in a
portfolio. American-style index options can be exercised at any time before the expiration date,
while European-style index options can only be exercised on the expiration date.

KEY TAKEAWAYS

 Index options are options to buy or sell the value of an underlying index.
 Index options have downside that is limited to the amount of premium paid and upside
that is unlimited.

What is an Exchange-Traded Option

An exchanged-traded option is a standardized contract to either buy (using a call option) or sell
(using a put option) a set quantity of a specific financial product (the underlying asset), on or
before a pre-determined date (the expiration date) for a pre-determined price (the strike price).

BREAKING DOWN Exchange-Traded Option

Exchange-traded options contracts are listed on exchanges such as the Chicago Board Options
Exchange (CBOE). The exchanges are overseen by regulators – including the Securities and
Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) – and are
guaranteed by clearing houses such as the Options Clearing Corporation (OCC). You can learn
more about ETFs that offer exchange traded options in the Investing for Beginners course.

Benefits of Exchange-Traded Options

Exchange-traded options, also known as "listed options," provide many benefits that distinguish
them from over-the-counter (OTC) options. Because exchange-traded options have
standardized strike prices, expiration dates and deliverables (the number of shares/contracts of
the underlying asset), they attract and accommodate larger numbers of traders.
This increased volume benefits traders by providing improved liquidity and lower costs. The more
traders there are for a specific options contract, the easier it is for interested buyers to identify
willing sellers and the narrower the bid-ask spreadbecomes.

The standardization of exchange-traded options also enables clearing houses to guarantee that
options contract buyers will be able to exercise their options – and that options contract sellers
will fulfill the obligations they take on when selling options contracts – because the clearing
house can match any of a number of options contract buyers with any of a number of options
contract sellers. Clearing houses can do this more easily because the terms of the contracts are
all the same, making them interchangeable.

Drawbacks of Exchange-Traded Options

Exchange-traded options do have one significant drawback: unlike OTC options – which are not
standardized, but are negotiated directly between the buyer and the seller – exchange-traded
options cannot be customized to fit the buyer's or seller's specific goals. However, in most cases
traders will find exchange-traded options provide a wide enough variety of strike prices and
expiration dates to meet their trading needs.

What are OTC Options?

OTC options are exotic options that trade in the over-the-counter market rather than on a formal
exchange like exchange traded option contracts.

KEY TAKEAWAYS

 OTC options are exotic options that trade in the over-the-counter market rather than on
a formal exchange like exchange traded option contracts.
 OTC options are the result of a private transaction between the buyer and the seller.
 OTC option strike prices and expiration dates are not standardized, which allows
participants to define their own terms, and there is no secondary market.
Understanding OTC Options
Investors turn to OTC options when the listed options do not quite meet their needs. The
flexibility of these options is attractive to many investors. There is no standardization of strike
prices and expiration dates, so participants essentially define their own terms and there is
no secondary market. As with other OTC markets, these options transact directly between buyer
and seller. However, brokers and market makers participating in OTC option markets are usually
regulated by some government agency, like FINRA in the U.S.

With OTC options, both hedgers and speculators avoid the restrictions placed on listed options
by their respective exchanges. This flexibility allows participants to achieve their desired position
more precisely and cost-effectively.

Aside from the trading venue, OTC options differ from listed options because they are the result
of a private transaction between the buyer and the seller. On an exchange, options must clear
through the clearing house. This clearing house step essentially places the exchange as the
middleman. The market also sets specific terms for strike prices, such as every five points,
and expiration dates, such as on a particular day of each month.

Because buyers and seller deal directly with each other for OTC options, they can set the
combination of strike and expiration to meet their individual needs. While not typical, terms may
include almost any condition, including some from outside the realm of regular trading and
markets. There are no disclosure requirements, which represents a risk that counterparties will
not fulfill their obligations under the options contract. Also, these trades do not enjoy the same
protection given by an exchange or clearing house.

Finally, since there is no secondary market, the only way to close an OTC options position is to
create an offsetting transaction. An offsetting transaction will effectively nullify the effects of the
original trade. This is in stark contrast to an exchange-listed option where the holder of that
option merely has to go back to the exchange to sell their position.

What is a Quote
A quote is the last price at which a security or commodity traded, meaning the most recent price
to which a buyer and seller agreed and at which some amount of the asset was transacted.

The bid or ask quotes are the most current prices and quantities at which the shares can be
bought or sold. The bid quote shows the price and quantity of which a current buyer is willing to
purchase the shares, while the ask shows what a current participant is willing to sell the shares
for.

This is also known as an asset's "quoted price."

BREAKING DOWN Quote

Quotes for stock and bond prices change throughout the trading day as new transactions occur
one after another in a continual stream of trades. When a stock quote is referenced for a given
company, it represents the most recent price at which a trade was successfully executed for that
particular security.

Potential investors or sellers in a company are more concerned about the bid and ask quotes as
they reflect at what prices the stock can be bought or sold, while the price quote as defined above
shows the price at which the stock traded most recently.

Quotes as Part of an Investment Strategy

Historical quotes may be referenced by investors for the sake of examining potential trends in a
security’s market activity and volatility. Quotes can be represented in a relation to an instance of
time, allowing for comparisons with comparable periods. For instance, investors might reference
quotes from the same day, one year apart in order to chart the potential trajectory for the
security. They could also compare quotes across a day of trading, especially if there is volatility,
in order to develop an investing strategy in response to the activity.
Quotes may be provided by a variety of outlets, such as investment news sites and trading
platforms. There may be a delay in the reporting of such quotes, especially from free services
that are publically available. Trading and investing platforms may offer quotes as close to real-
time as possible as a service to their subscribers. This may be especially crucial for subscribers
who want to be able to make decisions on their trading activity as quotes become available.
Investing platforms might also allow users to set up quote-driven alerts that are sent when shares
cross certain thresholds. Such notifications can also be tied to automated responses. For
example, an investor might put a sell order in place that is contingent on receiving a quote that
shares of a security have reached a desired threshold.

Trading

A derivative is a financial security with a value that is reliant upon or derived from, an underlying
asset or group of assets—a benchmark. The derivative itself is a contract between two or more
parties, and the derivative derives its price from fluctuations in the underlying asset.

The most common underlying assets for derivatives are stocks, bonds, commodities, currencies,
interest rates, and market indexes. These assets are commonly purchased through brokerages.

What Is a Margin?
A margin is the money borrowed from a brokerage firm to purchase an investment. It is the
difference between the total value of securities held in an investor's account and the loan
amount from the broker. Buying on margin is the act of borrowing money to buy securities. The
practice includes buying an asset where the buyer pays only a percentage of the asset's value
and borrows the rest from the bank or broker. The broker acts as a lender and the securities in
the investor's account act as collateral.

What is Clearing?
Clearing is the procedure by which financial trades settle - that is, the correct and timely transfer
of funds to the seller and securities to the buyer. Often with clearing, a specialized organization
acts as intermediary and assumes the role of tacit buyer and seller in a transaction, to reconcile
orders between transacting parties. Clearing is necessary for the matching of all buy and sell
orders in the market. It provides smoother and more efficient markets as parties can make
transfers to the clearing corporation rather than to each individual party with whom
they transact.

KEY TAKEAWAYS

 Clearing is the procedure by which financial trades settle – that is, the correct and timely
transfer of funds to the seller and securities to the buyer.
 Often with clearing, a specialized organization acts as an intermediary known as a
clearinghouse, and assumes the role of tacit buyer and seller in a transaction to reconcile
orders between transacting parties.
  Clearing is necessary for the matching of all buy and sell orders in the market, providing
smoother and more efficient markets as parties can make transfers to the clearing
corporation rather than to each individual party with whom they transact.
 When trades don't clear, the resulting out trades can cause real monetary losses.

Regulation of derivative

Various models exist for the regulation of derivative products across the globe. In some countries,
all financial markets including those for commodity derivatives and securities derivatives are
organised under one regulator. Certain countries keep money market operations exclusively
under Central Bank and all the other segments of financial markets under a separate regulator.
Some countries have a very fragmented system of regulation with separate regulators for each
class of product. In many jurisdictions, the market for non-standardised contracts or better
known as over the counter market or negotiated market are not under any specific regulators.

Derivatives instruments in India are regulated by the Reserve Bank of India, Securities and
Exchange Board of India (SEBI) and Forward Markets Commission (FMC). Subsequent to the
passing of the Finance Act 2015, FMC was merged with SEBI with effect from 29 September 2015.

The framework for regulating derivative transactions is provided in the various Acts of
Government of India such as Securities Contracts (Regulation) Act, 1956, Reserve Bank of India
Act, 1934, Forward Contracts (Regulation) Act 1952 and related Rules, Regulations, Guidelines,
Circulars etc. Of these the Forward Contracts Regulation Act or FCRA would be repealed following
the merger of FMC with SEBI.

Exchange traded equity and commodity derivatives markets are regulated by Securities and
Exchange Board of India (SEBI). Prior to the merging of FMC with SEBI, the Forward Markets
Commission (FMC) regulated the exchange traded commodity derivatives market in India.
Reserve Bank of India (RBI) as well as SEBI jointly regulates the exchange traded foreign currency
and interest rate futures. The foreign currency, interest rate and credit derivatives traded in
the over the counter (OTC) market is under the jurisdiction of RBI and is permitted as long as at
least one of the parties in the transaction is regulated by RBI.

To understand the size of each segment, the turnover in various derivative contracts over the
past three years across the segments is given below. As may be seen, the OTC turnover as a
percentage of exchange traded securities derivatives turnover has decreased over the years.
What convertible securities are
Convertible securities are typically either bonds or preferred stock that combines typical features
of their respective asset class with exposure to price changes in the common shares of the
company. Convertible bonds will usually carry an interest rate, par value, and maturity date just
like any other bond. Convertible preferred stock will have a stated preference amount in the
event of liquidation, and it also often has a set dividend rate that acts much like a coupon rate
for a bond.
Convertible securities also give investors the right to exchange their bond or shares for common
stock of the company. Each convertible security will give specifics on the number of shares you'll
receive upon conversion, as well as the expiration date by which the security must be converted.
In some cases, conversion is mandatory, while other convertible securities leave the conversion
decision at the discretion of the owner.
What warrants are
Warrants, on the other hand, typically don't have any intrinsic value of their own. Unlike
convertible securities, there's no underlying bond or preferred shares that give the warrant
owner any additional rights. The only value that the warrant has comes from its conversion
feature.
Warrants resemble options in that they typically require investors to make an additional payment
within a specified time frame in order to exercise the warrant and receive common stock in
exchange. Warrants tend to have longer lifespans than ordinary options, with expiration dates as
much as 10 years into the future being relatively common. Investors aren't required to exercise
warrants, but they're worthless after they expire unexercised.
Both warrants and convertible securities have their place within the capital structure of a
company. The investments have some things in common, but their differences also have
maximum value to different sets of investors. Those who want maximum reward will prefer
warrants, but those who want some protection from worst-case scenarios will gravitate toward
convertible securities.
What is a Cash Market
A cash market is a marketplace for the immediate settlement of transactions involving
commodities and securities. In a cash market, the exchange of goods and money between the
seller and the buyer takes place in the present, as opposed to the futures market where such an
exchange takes place on a specified future date. This type of market is also known as the spot
market, since transactions are settled on the spot.

Cash Market
Cash market transactions can take place on either a regulated exchange or over the
counter (OTC). In contrast, transactions involving futures are conducted exclusively on
exchanges, while forward transactions, such as currency forwards, are generally executed on the
OTC market. For a specific commodity, the price in the cash market is usually less than its price
in the futures market. This is because there are carrying costs, such as storage and insurance,
involved in holding a commodity until it can be delivered at some point in the future.
An Example of a Cash Market
The New York Stock Exchange (NYSE), using a real-world example, is a regulated cash market in
the United States. The NASDAQ would also be considered a cash market. Therefore, there can be
more than one cash market within an economic region.

Reasons for trading

1. Hedging risk exposure

Since the value of the derivatives is linked to the value of the underlying asset, the contracts are
primarily used for hedging risks. For example, an investor may purchase a derivative contract
whose value moves in the opposite direction to the value of an asset the investor owns. In this
way, profits in the derivative contract may offset losses in the underlying asset.

2. Underlying asset price determination

Derivates are frequently used to determine the price of the underlying asset. For example, the
spot prices of the futures can serve as an approximation of a commodity price.

3. Market efficiency
It is considered that derivatives increase the efficiency of financial markets. By using derivative
contracts, one can replicate the payoff of the assets. Therefore, the prices of the underlying asset
and the associated derivative tend to be in equilibrium to avoid arbitrage opportunities.

4. Access to unavailable assets or markets

Derivatives can help organizations get access to otherwise unavailable assets or markets. By
employing interest rate swaps, a company may obtain a more favorable interest rate relative to
interest rates available from direct borrowing.

Risk Management

Risk management occurs everywhere in the financial world. It occurs when an investor buys low-
risk government bonds over riskier corporate bonds, when a fund manager hedges his currency
exposure with currency derivatives, and when a bank performs a credit check on an individual
before issuing a personal line of credit. Stockbrokers use financial instruments
like options and futures, and money managers use strategies like portfolio and investment
diversification to mitigate or effectively manage risk.

Importance of risk management

 Saving valuable resources: time, income, assets, people and property can be saved if fewer
claims occur
 Creating a safe and secure environment for staff, visitors, and customers
 Reducing legal liability and increasing the stability of your operations
 Protecting people and assets from harm
 Protecting the environment
 Reducing your threat of possible litigation
 Defining your insurance needs to save on unnecessary premiums

Option Pricing

Option pricing refers to the amount per share at which an option is traded. Options are derivative
contracts that give the holder (the "buyer") the right, but not the obligation, to buy or sell
the underlying instrument at an agreed-upon price on or before a specified future date. Although
the holder of the option is not obligated to exercise the option, the option writer (the "seller")
has an obligation to buy or sell the underlying instrument if the option is exercised.

Terminology of option pricing

 Long — This term can be pretty confusing. On this site, it usually doesn’t refer to time. As
in, “Ally Invest never leaves me on hold for long.” Or distance, as in, “I went for a long
jog.”
When you’re talking about options and stocks, “long” implies a position of ownership.
After you have purchased an option or a stock, you are considered "long" that security in
your account.
 Short — Short is another one of those words you have to be careful about. It doesn’t refer
to your hair after a buzz cut, or that time at camp when you short-sheeted your
counselor’s bed.
If you’ve sold an option or a stock without actually owning it, you are then considered to
be “short” that security in your account. That’s one of the interesting things about
options. You can sell something you don’t actually own. But when you do, you may be
obligated to do something at a later date. Read on to get a clearer picture of what that
something might be for specific strategies.
 Strike Price — The pre-agreed price per share at which stock may be bought or sold under
the terms of an option contract. Some people refer to the strike price as the “exercise
price”.
 In-The-Money (ITM) — For call options, this means the stock price is above the strike
price. So if a call has a strike price of $50 and the stock is trading at $55, that option is in-
the-money.
 For put options, it means the stock price is below the strike price. So if a put has a strike
price of $50 and the stock is trading at $45, that option is in-the-money.
This term might also remind you of a great song from the 1930s that you can tap dance
to whenever your option strategies go according to plan.
 Out-of-The-Money (OTM) — For call options, this means the stock price is below the
strike price. For put options, this means the stock price is above the strike price. The price
of out-of-the-money options consists entirely of “time value.”
 At-The-Money (ATM) — An option is “at-the-money” when the stock price is equal to the
strike price. (Since the two values are rarely exactly equal, when purchasing options the
strike price closest to the stock price is typically called the “ATM strike.”)
 Intrinsic Value — The amount an option is in-the-money. Obviously, only in-the-money
options have intrinsic value.
 Time Value — The part of an option price that is based on its time to expiration. If you
subtract the amount of intrinsic value from an option price, you’re left with the time
value. If an option has no intrinsic value (i.e., it’s out-of-the-money) its entire worth is
based on time value.
Let us also take this opportunity to say while you’re reading this site, you’re spending your
time valuably.
Exercise — This occurs when the owner of an option invokes the right embedded in the
option contract. In layman’s terms, it means the option owner buys or sells the underlying
stock at the strike price, and requires the option seller to take the other side of the trade.
Interestingly, options are a lot like most people, in that exercise is a fairly infrequent
event. (See Cashing Out Your Options.)
 Assignment — When an option owner exercises the option, an option seller (or “writer”)
is assigned and must make good on his or her obligation. That means he or she is required
to buy or sell the underlying stock at the strike price.
 Index Options vs. Equity Options — There are quite a few differences between options
based on an index versus those based on equities, or stocks. First, index options typically
can’t be exercised prior to expiration, whereas equity options typically can.
Second, the last day to trade most index options is the Thursday before the third Friday
of the expiration month. (That’s not always the third Thursday of the month. It might
actually be the second Thursday if the month started on a Friday.) But the last day to trade
equity options is the third Friday of the expiration month.
Third, index options are cash-settled, but equity options result in stock changing hands.
NOTE: There are several exceptions to these general guidelines about index options. If
you’re going to trade an index, you must take the time to understand its characteristics.
See What is an Index Option? or ask an Ally Invest broker.
  Stop-Loss Order - An order to sell a stock or option when it reaches a certain price (the
stop price). The order is designed to help limit an investor’s exposure to the markets on
an existing position.
Here’s how a stop-loss order works: first you select a stop price, usually below the current
market price for an existing long position. By choosing a price below the current market,
you’re basically saying, “This is the downside point where I would like to get out of my
position.”
Past this price, you no longer want the cheese; you just want out of the trap. When your
position trades at or through your stop price, your stop order will get activated as a
market order, seeking the best available market price at that time the order is triggered
to close out your position.
 Any discussion of stop orders isn’t complete without mentioning this caveat: they do not
provide much protection if the market is closed or trading is halted during the day. In
those situations, stocks are likely to gap — that is, the next trade price after the trading
halt might be significantly different from the prices before the halt. If the stock gaps, your
downside “protective” order will most likely trigger, but it’s anybody’s guess as to what
the next available price will be.
 Standard Deviation — This site is about options, not statistics. But since we're be using
this term a lot, let’s clarify its meaning a little.
If we assume stocks have a simple normal price distribution, we can calculate what a one-
standard-deviation move for the stock will be. On an annualized basis the stock will stay
within plus or minus one standard deviation roughly 68% of the time. This comes in handy
when figuring out the potential range of movement for a particular stock.
For simplicity’s sake, here we assume a normal distribution. Most pricing models assume
a log normal distribution. Just in case you’re a statistician or something.

Continuous-time models are written in differential equations. They are probably more
mainstream in science and engineering, and studied more extensively, than discrete-time
models, because various natural phenomena (e.g., motion of objects, flow of electric current)
take place smoothly over continuous time. A general mathematical formulation of a first-order
continuous-time model is given by this:
Dx/dt =F (x,t)
Integrating a continuous-time model over t gives a trajectory of the system’s state over time.
While integration could be done algebraically in some cases, computational simulation (=
numerical integration) is always possible in general and often used as the primary means of
studying these models. One fundamental assumption made in continuous-time models is that
the trajectories of the system’s state are smooth everywhere in the phase space, i.e., the limit in
the definition above always converges to a well-defined value. Therefore, continuous-time
models don’t show instantaneous abrupt changes, which could happen in discrete-time models.
What Is the Arbitrage Pricing Theory (APT)?
Arbitrage pricing theory (APT) is a multi-factor asset pricing model based on the idea that an
asset's returns can be predicted using the linear relationship between the asset’s expected
return and a number of macroeconomic variables that capture systematic risk. It is a useful tool
for analyzing portfolios from a value investing perspective, in order to identify securities that
may be temporarily mispriced.

The Formula for the Arbitrage Pricing Theory Model Is

E(R)i=E(R)z+(E(I)−E(R)z)×βn
where:
E(R)i=Expected return on the asset
Rz=Risk-free rate of return
The Formula for the Arbitrage Pricing Theory Model Is

Pricing Restriction On Calls

What are Boundary Conditions?
Boundary conditions are the maximum and minimum values used to indicate where the price of
an option must lie. Boundary conditions are used to estimate what an option may be priced at,
but the actual price of the option may be higher or lower than what is set as the boundary
condition.

For all options contracts, the minimum boundary value is always zero, since options cannot be
priced at negative money. Meanwhile, maximum boundary values will differ depending on the
whether the option is a call or put, and if it is an American or European style option.

Understanding Boundary Conditions

Before the introduction of binomial tree pricing models and the Black-Scholesmodel, investors
and traders relied heavily on boundary conditions to set the minimum and maximum possible
values for the call and put options that they were pricing. These boundary conditions change
according to whether the option is American or European, since American options can
be exercised early. This ability to exercise at any point prior to the expiration date affects the way
the price is calculated, and American options will trade at a premium relative to equivalent
European options by virtue of this feature.

Minimum and Maximum Boundary Conditions

The absolute minimum value for an option is zero, since an option cannot be sold for a negative
amount of money. The maximum value in a boundary condition is set to the current value of the
underlying asset. If the price of the underlying asset is greater than the price indicated in the call
option then the investor would not exercise the option, since exercising the option would result
in the investor paying more than the market price. This is the case for both a European call and
an American call.

The maximum value of a put option is reached when the underlying asset has no worth, such as
in the case of a company's bankruptcy when the underlying security is a stock. For a European
put option, the maximum value computed as is the present value of the exercise price. This is
because European options cannot be exercised at any point, and instead can only be exercised
at expiration at a specified price. The value of an American option must be at least as great as a
European option.

While technically the maximum value of an asset could be set at infinity – an asset could increase
in value with no ceiling – this is considered impractical. The value of the underlying asset is likely
to fall within a reasonable boundary that can be modeled with standard deviations or other
stochastic methods.

Upper and Lower Bonds

What are upper and lower bounds of options?

One important principle while valuing options is that at any time, the value of a call or a put
cannot exceed certain limits – on the higher side as well as on the lower side. In option lingo, the
maximum limit up to which an option value can go on the higher side is commonly referred to as
‘upper bounds of an option’ and the maximum limit below which an option value cannot fall is
called the ‘lower bounds of an option’.
These maximum limits will have to be discussed for European and American options separately.
We first take up the upper and lower bounds of European calls.

Upper bounds of European call values:

Let’s assume that the call value of an option is 55 and the underlying stock is trading at 50 in the
spot market. In such a scenario, anybody can write the call and sell the stock on spot, and take
home the difference of 5 per share. Hence, it’s clear that the call value at expiry cannot rise
beyond the value of the underlying stock.
Now, let’s further assume that the company has announced a dividend of 5 per share. Dividend,
when paid, decreases the value of shares to that extent. Hence on expiry, the stock will be valued
at 45 (50 – 5) in the spot market and logically, the call value cannot exceed 45 per share.
This brings us to the first principle in option value – the upper bound value of an European call
can never rise beyond the value of the underlying stock. When the dividend is known with
certainty, the call values cannot rise beyond the spot value of the stock less present value of the
dividend.
Lower bounds of European call values:
What would be the lowest value for an European call? It should be zero. It cannot fall below that,
Right? For the call value to be at zero, the stock value should also fall to zero. If the stock value is
above zero (say 2) the minimum value of call should be the present value of Rs 2 (strike price).