Option traders use various option pricing models to calculate theoretical option values. These mathematical models use certain fixed knowns in the present – things like underlying price, strike price and days until expiration – along with forecasts (or assumptions) for factors such as implied volatility, to compute the theoretical value for specific options at certain points in time. Variables fluctuate over the life of the option, and the option's theoretical value adapts to reflect these changes.
Most professional traders and investors who trade large option positions rely on theoretical value updates to monitor the changing risk and value of their option positions, and assist with trading decisions. Many options trading platforms provide up-to-the-minute option price modeling values, and option pricing calculators can be found online at various websites, including the Options Industry Council. The basic calculator shown in Figure 3 lets you choose the model/exercise type, and then prompts you to enter various fields, including the contract type, spot price of the underlying, expiration date, interest rate, dividend amount (if applicable) and strike price.
|Figure 3 The options calculator from the Options Industry Council lets you choose either a Binomial model (for American style options) or the Black-Scholes model (for European options).|
Options Pricing: Black-Scholes Model
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