What does the price of an option mean?
Definition. The amount per share that an option buyer pays to the seller. The option premium is primarily affected by the difference between the stock price and the strike price, the time remaining for the option to be exercised, and the volatility of the underlying stock.
An option pricing theory is any model or theory-based approach for calculating the fair value of an option. Today, the most commonly used models are the Black-Scholes model and the binomial model.
- The Black Scholes model, also known as the Black-Scholes-Merton 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 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 Binomial Theorem is a quick way (okay, it's a less slow way) of expanding (or multiplying out) a binomial expression that has been raised to some (generally inconveniently large) power. For instance, the expression (3x – 2)10 would be very painful to multiply out by hand.
The formula, developed by three economists – Fischer Black, Myron Scholes and Robert Merton – is perhaps the world's most well-known options pricing model. The Black-Scholes model makes certain assumptions: The option is European and can only be exercised at expiration.
- Cash dividends affect option prices through their effect on the underlying stock price. Because the stock price is expected to drop by the amount of the dividend on the ex-dividend date, high cash dividends imply lower call premiums and higher put premiums.
- Historical volatility is the annualized standard deviation of past stock price movements. It measures the daily price changes in the stock over the past year. In contrast, implied volatility (IV) is derived from an option's price and shows what the market implies about the stock's volatility in the future.
- Delta hedging is an options strategy that aims to reduce, or hedge, the risk associated with price movements in the underlying asset, by offsetting long and short positions. For example, a long call position may be delta hedged by shorting the underlying stock.
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.
- The overall value of an option is actually determined by six factors: strike price, current market price of underlying stock, dividend yield, prime interest rate, proximity to expiration date, and the volatility of the stock prices over the course of the option.
- Call options give the holder the right to buy 100 shares of an underlying stock at a specific price, known as the strike price, up until a specified date, known as the expiration date. The market price of the call option is called the premium. It is the price paid for the rights that the call option provides.
- A call price is the price at which a bond or a preferred stock can be redeemed by the issuer. This price is set at the time the security is issued. Also referred to as "redemption price."
Updated: 9th October 2018