Notional value is the estimated price of an option, calculated using mathematical equations such as the Black-Scholes model. It helps investors determine whether buying or selling a security is a good idea and allows for projecting performance based on different scenarios. Comparing notional value to the current market price helps determine potential returns.
Sometimes referred to as fair or notional value, a notional value is the estimated price of an option. Option pricing may have to do with buying, selling, or a combination of both. In most cases, this value is calculated using some specific type of mathematical equation. There are several of these models in use today.
One of the most popular models for estimating option pricing is the Black-Scholes option pricing model. First introduced in 1973, this formula was the brainchild of Fischer Black and Myron Scholes. Regarded as highly accurate, the concept quickly gained attention and remains one of the most viable formulas in common use today.
Calculating the theoretical value is useful to investors in several ways. First, determining a notional value for the option or options, given specific market conditions, can provide insight into whether buying or selling the security is a good idea. The theoretical value, of course, is based on the quality of the assumptions made regarding the performance of the market in general and the performance of the option in particular.
Second, calculating a notional value allows the investor to participate in projecting performance based on several different scenarios. The Black-Scholes approach, as well as other mathematically based formulas to project theoretical value, allow the inclusion of different figures. By running various projections, the investor can identify the most likely future situation that will apply, while still being prepared for what would happen if one or more factors turn out to be different.
Notional value is one of the most basic tools used in trading today. By comparing the estimated value to the current market price of an option, it is possible to determine whether the purchase or sale is likely to generate a return at some point in the future. Brokers and investors often use this concept before making any type of investment decision.
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