Option Pricing Theory

AAA

DEFINITION of 'Option Pricing Theory'

Any model- or theory-based approach for calculating the fair value of an option.

The most commonly used models today are the Black-Scholes model and the binomial model. Both theories on options pricing have wide margins for error because their values are derived from other assets, usually the price of a company's common stock. Time also plays a large role in option pricing theory, because calculations involve time periods of several years and more. Marketable options require different valuation methods than non-marketable ones, such as those given to company employees.

INVESTOPEDIA EXPLAINS 'Option Pricing Theory'

How stock options should be valued has become an important debate in the past few years because U.S. companies are now required to expense the cost of employee stock options on their earnings statements. For many young companies trading on the stock exchanges today, this expense will be considerable no matter what valuation methods are used. The need for consistent and accurate treatment of this increasing expense provides incentive for the creation of new and innovative solutions to option pricing theory.

RELATED TERMS
  1. Gamma Pricing Model

    An equation for determining the fair market value of a European-style ...
  2. Decision Tree

    A schematic tree-shaped diagram used to determine a course of ...
  3. Black's Model

    A variation of the popular Black-Scholes options pricing model ...
  4. Implied Volatility - IV

    The estimated volatility of a security's price. In general, implied ...
  5. Black Scholes Model

    A model of price variation over time of financial instruments ...
  6. Binomial Option Pricing Model

    An options valuation method developed by Cox, et al, in 1979. ...
RELATED FAQS
  1. What risks should I consider taking a short put position?

    The risks to consider before taking a short put position are the odds of sustained weakness in the asset price and a spike ... Read Full Answer >>
  2. What happens if a software glitch fails to execute the strike price I set?

    If you've ever suffered the frustrating experience of having an order not filled or had a strike price fail to execute because ... Read Full Answer >>
  3. In what market situations might a short put be a profitable trade?

    Short puts would be a profitable trade in low-volatility bull markets or range-bound markets. Selling puts is a strategy ... Read Full Answer >>
  4. How does implied volatility impact the pricing of options?

    Implied volatility is an important aspect of the time value premium of an option. As implied volatility increases, call and ... Read Full Answer >>
  5. What is the relationship between implied volatility and the volatility skew?

    The volatility skew refers to the shape of implied volatilities for options graphed across the range of strike prices for ... Read Full Answer >>
  6. How is a short call used in a collar option strategy?

    An investor uses a short call sold above the current market price to collect a premium in a collar option strategy. The core ... Read Full Answer >>
Related Articles
  1. Investing Basics

    Pin Down Stock Price With Real Options

    How can you assign a value to what a company may do with its business in the future? We explain how it works.
  2. Options & Futures

    The "True" Cost Of Stock Options

    Perhaps the real cost of employee stock options is already accounted for in the expense of buyback programs.
  3. Options & Futures

    The Ins And Outs Of Selling Options

    Selling options can seem intimidating but with these tips, you can enter the market with confidence.
  4. Bonds & Fixed Income

    Accounting and Valuing Employee Stock Options

    Learn the different accounting and valuation treatments of ESOs, and discover the best ways to incorporate these techniques into your analysis of stock.
  5. Investing Basics

    What is a Greenshoe Option?

    A greenshoe option is a provision in an underwriting agreement that allows the underwriter to buy up to 15% of the shares in an IPO at the offer price.
  6. Investing Basics

    What Does a Clearing House Do?

    A clearing house is a third-party agency or separate entity that acts as a go-between for buyers and sellers in financial markets.
  7. Options & Futures

    How The New NYSE Binary Options Work

    The New York Stock Exchange has launched its own version of binary options called Binary Return Derivatives Options or ByRDs.
  8. Mutual Funds & ETFs

    4 Ways You Can Invest In Gold Without Holding It

    Owning gold can be a store of value and a hedge against unexpected inflation. Holding physical gold, however, can be cumbersome and costly. Fortunately, there are several ways to own gold without ...
  9. Active Trading Fundamentals

    How To Short Amazon Stock

    With the stock reaching all-time highs and the company gambling on several new business lines, many investors may feel it's a good time to short sell Amazon.
  10. Investing Basics

    What is Meant by Implied Volatility?

    The estimated volatility of a security's price.

You May Also Like

Hot Definitions
  1. National Currency

    The currency or legal tender issued by a nation's central bank or monetary authority. The national currency of a nation is ...
  2. Treasury Yield

    The return on investment, expressed as a percentage, on the debt obligations of the U.S. government. Treasuries are considered ...
  3. Bund

    A bond issued by Germany's federal government, or the German word for "bond." Bunds are the German equivalent of U.S. Treasury ...
  4. European Central Bank - ECB

    The central bank responsible for the monetary system of the European Union (EU) and the euro currency. The bank was formed ...
  5. Quantitative Easing

    An unconventional monetary policy in which a central bank purchases private sector financial assets in order to lower interest ...
  6. Current Account Deficit

    A measurement of a country’s trade in which the value of goods and services it imports exceeds the value of goods and services ...
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!