Stock options come in two types: call options, which allow the purchase of an asset at a fixed price, and put options, which allow the sale of an asset at a fixed price. Options are priced using the Black-Scholes model, which relies on accurate forecasts of future volatility. Strike prices far from the current price of the underlying asset require an additional level of margin, resulting in a “volatility smile.” Option pricing must also consider dividends and interest rates.
Stock options come in two varieties. A call option is the right to purchase a specified asset at a fixed price on or before a specified date. A put option is the right to sell a specified asset at a fixed price on or before a specified date. The asset to be bought or sold is called the underlying, the strike price or strike price is the price at which the underlying will be bought or sold, and the expiration date is the time the option can no longer be exercised.
Options are generally priced using the Black-Scholes model. It combines the time remaining to expiration, the strike price, the current price of the underlying, and an estimate of future volatility known as the implied volatility (IV) to generate a theoretical price for an option.
Because implied volatility is the only unknown input, proper option pricing depends entirely on accurate forecasts of future volatility. The usual approach is to measure the actual volatility of the underlying in the recent past, adjust for anticipated news events, such as an upcoming earnings release, and add a margin of safety. This approach works quite well for liquid (heavily traded) options.
Pricing options for strike prices far from the current price of the underlying is a bit more complicated. Partly as a reflection of their lesser liquidity, and partly in recognition that large unexpected price movements can occur, such options have an additional level of margin added to their price.
This results in something known as the “volatility smile”. Black Scholes can be used in reverse to calculate the implied volatility (IV) needed to generate a given price; Plotting the IV for a wide range of strike prices will result in a plot that resembles a smile. That is, the further the strike price moves from the underlying price, the higher the IV will be.
Option pricing must also take into account some other market realities. If the underlying pays dividends, and one is due before maturity, the pricing model must take this into account. Option pricing is also sensitive to interest rates; If the general economic situation is one in which interest rates are likely to move significantly in the near future, adjustments will be necessary.
Smart Asset.
Protect your devices with Threat Protection by NordVPN
