What are The Different Pricing Models for Options?

Option pricing is the process of determining the theoretical value of an option derivative. The method considers vital variables from the current scenarios and applies them to various assumptions. Understanding different pricing models on the market can help you develop a well-thought-out strategy. Let’s begin by looking at the factors that affect options pricing.

What are the factors affecting Options Pricing?

The following three variables primarily influence options pricing.

• Intrinsic value: It denotes the monetary value of a specific contract that an investor can obtain if he exercises his option today. You can arrive at this value by deducting the call option strike price from the current trading value of the security.

• Time value: The time left to the option’s expiry has a monetary value within the contract. If the expiration date is far away, the likelihood of the asset’s trading price exceeding the strike price is high. You can calculate the time value by subtracting the intrinsic value from the option’s premium.

• Volatility: It represents how actively the price of the underlying security fluctuates. Volatility is determined using the beta. Furthermore, investors can use historical or implied volatility to get precise results.

Types of Options Pricing Model

The three most common pricing models are–

1. Black Scholes

Economists Myron Scholes and Fischer Black proposed the Black Scholes theory in 1973. The model considers five factors for options pricing: volatility, strike price, expiry date, risk-free rate, and underlying asset price. However, for some stocks, the model also considers dividend yields.

The Black Scholes model works upon the following market and stock price assumptions.

• The risk-free rate remains constant.
• There are no taxes or transactional costs involved. 
• Since asset prices can never fall below zero, they follow a log-normal distribution.
• You can utilise the proceeds for short selling. 
• There are no better investment opportunities that do not involve risk.

The Black Scholes model applies to European-style trade only. 

2. Binomial Model

A binomial pricing model is based on a binomial tree, which depicts the possible price of the underlying asset over various periods. The binomial pricing model assumes that the present value of the option contract equals the current value of the investment’s probability-weighted future payoffs.

Assumptions of a binomial model–

• The risk-free rate remains constant.
• The underlying stock does not provide any returns.
• The asset price at any time can either move up or down. 
• There are no taxes or transactional costs involved.
• Investors are willing to take risks.
• The discount factor remains constant throughout the contract’s term.

The binomial model is best suited for embedded or American options.

3. Monte Carlo Simulation

The Monte Carlo method calculates the probability of various outcomes you cannot predict due to random variable interference. It focuses on samples that repeat often and assigns a random value to them. The procedure is repeated several times, each time with a different value assigned to the dependent variable. After completing these steps, the outputs are averaged to determine the price.

The Monte Carlo options pricing model depends on two components. The first is drift, which represents asset price movement in a directional direction, and the second is market volatility, which is represented by random input.

Important Considerations: Options Pricing Models

Implied Volatility

While option pricing models assume constant volatility, the market may have differing opinions. Implied volatility, inferred from option prices, provides insights into traders’ expectations regarding future price movements.

Dividends 

In the Indian context, where dividends are significant, the presence of dividends impacts option pricing. The Black-Scholes model can be adapted to account for dividends by adjusting the stock price.

Real Market Dynamics

Option pricing models simplify market complexities. Factors like market sentiment, macroeconomic indicators, and geopolitical events can significantly influence option prices.

Final Words

The primary objective of the option pricing model is to calculate the likelihood that a specific contract will be exercised. In addition, it provides information about volatility and assists in decoding the bid-ask spread at the contract’s expiry.

FAQs:

______________________________________________________________________________________

Disclaimer: Investments in the securities market are subject to market risks; read all the related documents carefully before investing.