What are Option Pricing Models?

Option Pricing Models are mathematical models that use certain variables to calculate
the theoretical value of an option. The theoretical value of an option is an estimate of
what an option should be worth using all known inputs. In other words, option pricing
models provide us a fair value of an option. Knowing the estimate of the fair value of an
option, finance professionalscould adjust their trading strategies and portfolios.
Therefore, option pricing models are powerful tools for finance professionals involved in
options trading.

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.

 
Risk-neutral Probability
Before we start discussing different option pricing models, we should understand the
concept of risk-neutral probabilities, which are widely used in option pricing and may be
encountered in different option pricing models.

The risk-neutral probability is a theoretical probability of future outcomes adjusted for

risk. There are two main assumptions behind this concept:

1. The current value of an asset is equal to its expected payoff discounted at the risk-free
rate.
2. There are no arbitrage opportunities in the market.

The risk-neutral probability is the probability that the stock price would rise in a risk-
neutral world. However, we neither assume that all the investors in the market are risk-
neutral, nor the fact that risky assets will earn the risk-free rate of return. This
theoretical value measures the probability of buying and selling the assets as if there
was a single probability for everything in the market.

Binomial Option Pricing Model

The simplest method to price the options is to use a binomial option pricing model. This
model uses the assumption of perfectly efficient markets. Under this assumption, the
model can price the option at each point of a specified time frame.

Under the binomial model, we consider that the price of the underlying asset will either
go up or down in the period.

Black-Scholes Model
The Black-Scholes model is another commonly used option pricing model. This model
was discovered in 1973 by the economists Fischer Black and Myron Scholes. Both
Black and Scholes received the Nobel Memorial Prize in economics for their discovery.

The Black-Scholes model was developed mainly for pricing European options on stocks.
The model operates under certain assumptions regarding the distribution of the stock
price and the economic environment. The assumptions about the stock price
distribution include:

 Continuously compounded returns on the stock are normally distributed and

independent over time.
 The volatility of continuously compounded returns is known and constant.
 Future dividends are known (as a dollar amount or as a fixed dividend yield).
The assumptions about the economic environment are:

 The risk-free rate is known and constant.

 There are no transaction costs or taxes.
 It is possible to short-sell with no cost and to borrow at the risk-free rate.

Nevertheless, these assumptions can be relaxed and adjusted for special

circumstances if necessary. In addition, we could easily use this model to price options
on assets other than stocks (currencies, futures).

The Black-Scholes model is mainly used to calculate the theoretical value of European-
style options and it cannot be applied to the American-style options due to their feature
to be exercised before the maturity date.

Monte-Carlo Simulation
Monte-Carlo simulation is another option pricing model we will consider. The Monte-
Carlo simulation is a more sophisticated method to value options. In this method, we
simulate the possible future stock prices and then use them to find the discounted
expected option payoffs.

Mixed strategies in options trading

Call and put options and the buying and writing of options can be combined to try to profit
from expected conditions in the market. Some of such strategies are as follows:
Cases where a trader either buys or writes options but does not do both
Straddle – a call and a put at the same strike price and expiry date
Strangle – a call and a put for the same expiry date but at different strike prices
Strap – two calls and one put with the same expiry dates; the strike prices might be the
same or different
Strip – two puts and one call with the same expiry date; again strike prices might be the
same or different
In general, the buyer of these options is hoping for market prices to move sharply but is
uncertain whether they will rise or fall. The buyer of a strap gains more from a price rise
than from a price fall; the buyer of a strip gains more from a price fall. The writer in all
four cases is hoping that the market will remain stable, with little change in price during
the life of the option.
Spreads: combinations of buying and writing options
Butterfly – buying two call options, one with a low exercise price, the other with a high
exercise price, and writing two call options with the same intermediate strike price or the
reverse.
Condor – similar to a butterfly, except that the call options which are written have
different intermediate prices.
Both a butterfly and a condor are vertical spreads – all options bought or sold have the
same expiry date but different strike prices. Horizontal spreads have the same strike prices
but different expiry dates. With diagonal spreads both the strike prices and the expiry dates
are different. Other mixed strategies have equally improbable names. They include vertical
bull call; vertical bull spread; vertical bear spread; rotated vertical bull spread; rotated
vertical bear spread.