31 lines
2.1 KiB
Plaintext
31 lines
2.1 KiB
Plaintext
Price vs. Value: How Traders Use
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Option-Pricing Models
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Like in the common-life example just discussed, the right to buy or sell an
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underlying security—that is, an option—can have value, too. The specific
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value of an option is determined by supply and demand. There are several
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variables in an option contract, however, that can influence a trader’s
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willingness to demand (desire to buy) or supply (desire to sell) an option at
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a given price. For example, a trader would rather own—that is, there would
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be higher demand for—an option that has more time until expiration than a
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shorter-dated option, all else held constant. And a trader would rather own a
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call with a lower strike than a higher strike, all else kept constant, because it
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would give the right to buy at a lower price.
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Several elements contribute to the value of an option. It took academics
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many years to figure out exactly what those elements are. Fischer Black and
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Myron Scholes together pioneered research in this area at the University of
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Chicago. Ultimately, their work led to a Nobel Prize for Myron Scholes.
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Fischer Black died before he could be honored.
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In 1973, Black and Scholes published a paper called “The Pricing of
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Options and Corporate Liabilities” in the Journal of Political Economy ,
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that introduced the Black-Scholes option-pricing model to the world. The
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Black-Scholes model values European call options on non-dividend-paying
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stocks. Here, for the first time, was a widely accepted model illustrating
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what goes into the pricing of an option. Option prices were no longer wild
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guesswork. They could now be rationalized. Soon, additional models and
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alterations to the Black-Scholes model were developed for options on
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indexes, dividend-paying stocks, bonds, commodities, and other optionable
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instruments. All the option-pricing models commonly in use today have
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slightly different means but achieve the same end: the option’s theoretical
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value. For American-exercise equity options, six inputs are entered into any
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option-pricing model to generate a theoretical value: stock price, strike
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price, time until expiration, interest rate, dividends, and volatility. |