Showing posts with label option-premium-example. Show all posts
Showing posts with label option-premium-example. Show all posts

Option Premiums- Introduction

Option Premiums


As important as knowing the chances of a LEAP put winding up in the money is knowing whether the option in question is over- or underpriced. When it comes to long-term options, market makers use one of several analytic formulas to calculate option prices. This is because the computational complexity associated with multiperiod binomial models increases dramatically with the number of steps involved, thus restricting their applicability to standard, short-term option pricing.

Depending on the sophistication of the market maker, option pricing is typically determined either by straightforward use of the original pricing formula developed by Fischer Black and Myron Scholes in 1973 or by the use of later extensions of this formula by Robert Merton, Giovanni Barone-Adesi, and Robert Whaley. In a nutshell, the Black-Scholes model determines option prices for European-style options, ignoring the effects of dividends. The Merton model adjusts the Black-Scholes formula to take dividends into account; the Barone-Adesi and Whaley model adjusts the Black-Scholes-Merton formula for the early exercise potential present in American-style options.

The Black-Scholes Formula for Puts

The Black-Scholes formula for the put premium for European-style options with a zero dividend rate is given by:


P is the price of the underlying issue
S is the strike (exercise price) of the option
r is the risk-free interest rate in decimal form
t is the time in years till expiration
v is the annualized volatility in decimal form
and h is given by the formula:

When t approaches zero, h takes on one of two values:

1. if the stock price P equals or is greater than the strike price S
2. if P is less than S, the result of which shows that the value of the put goes to zero if P equals or is greater than S, or it approaches S - P if P is less than S.

The integrals are the standard normal distribution, and the same curve-fitting formula that can be used for their evaluation. Note that the right-hand integral is the probability that the put will wind up in the money.

The Black-Scholes Formula for Calls

For completeness, the corresponding Black-Scholes formula for the call premium is given by:

where P, S, r, t, and h are as defined earlier for the put formula. If the put price has already been calculated, one can use the shortcut formula (called the put-call parity formula) for the call, as follows:

The Effect of Dividends on Option Premiums

To keep things simple and conservative, all put premiums used in conducting the ten-year economic simulations were calculated using a zero dividend rate. The effect of dividends is to lower the price of calls and to increase the price of puts. If I were to assume that dividends were paid continuously through the year (rather than in the usual quarterly distribution), the Merton variation of the Black-Scholes pricing formula can be used. This formula takes the following form for puts:

where δ is the annual dividend rate, and h is modified as follows:

The right-hand integral is again the probability that the put will wind up in the money and is the one adopted for that purpose.

Numerical Example

The effect that dividends have on option premiums, consider the case where the strike price and stock price are both $100, the volatility is 0.35, the risk-free interest rate is 6 percent, there are 24 months till expiration, and the annual dividend rate is 2 percent. Applying the basic Black-Scholes formula yields a put premium for the zero-dividend case of $13.314. For the Merton variation, do the following:

Since S = P = $100, the parameter h is calculated as

Therefore, -h is -0.409112, and is -0.409112 + 0.4949748, or 0.0858628. From tables of the normal distribution or through the use of the curve-fitting formulas, we have N(-0.409112) = 1 - N(0.409112) = 0.341238 and N(0.0858628) = 0.534223. When the time to expiration is 2 years, e-0.02t is 0.960790 and e-0.06t is 0.886920. So from Equation the European put with its 2 percent annual dividend rate is calculated as

Thus, the annual 2 percent dividend has increased the price of the put by about $1.28 over the two-year period involved, thus showing that the effect of dividends on option pricing can indeed be significant.The pricing of American options is so complex that market makers often restrict their pricing formulas to that of Black-Scholes or one of its simpler variations. The pricing of American-style options is examined.

Implied Volatility

Now that you've seen how to calculate the LEAP put premium for European-style options using the Black-Scholes-Merton formulas, the question arises as to whether one can work the process backwards and determine volatility if the premium is supplied. The answer to this question is both yes and no. To begin, I first note that it is not possible to solve for the volatility directly. However, the volatility can be determined on a trial-and-error basis using a Newton-Raphson iterative search technique. A relatively short BASIC program for doing this follows. It is then illustrated by two numerical examples.

Numerical Examples

As examples of the results obtainable using the computer program, consider the two cases investigated earlier:

Stock Price: $100
Strike Price: $100
Risk-Free Interest Rate (e.g., .06): .06
Annual Dividend Rate (e.g., .02): 0
Time to Expiration in Months: 24
Put Premium: 13.314

No.                            VOLD                           VNEW                         F
1                               0.50000                         0.38384                         7.4605
2                               0.38384                         0.35707                         1.6934
3                               0.35707                         0.35144                         0.3544
4                               0.35144                         0.35029                         0.0723
5                               0.35029                         0.35005                         0.0147
6                               0.35005                         0.35001                         0.0030

Implied Volatility: 0.35003
Stock Price: $100
Strike Price: $100
Risk-Free Interest Rate (e.g., .06): .06
Annual Dividend Rate (e.g., .02): .02
Time to Expiration in Months: 24
Put Premium: 14.596

No                            .VOLD                          VNEW                              F
1                               0.50000                        0.38456                              7.3947
2                               0.38456                        0.35755                              1.7191
3                               0.35755                        0.35163                              0.3758
4                               0.35163                        0.35036                              0.0808
5                               0.35036                        0.35008                              0.0173
6                               0.35008                        0.35003                              0.0037

Implied Volatility: 0.35005

At first blush, this numerical method for determining volatilities from premiums looks like a great shortcut to the laborious process of calculating them from historical price information. All one has to do is to obtain the premium quoted, say, for a LEAP put, and then use the computer program to determine the volatility. The trouble with this is that it is not ordinarily possible to determine what pricing model the market maker used in the first place to arrive at the option premium quoted. The market maker may have used Black-Scholes, or the Merton variation, or a multiperiod binomial model, or even a more sophisticated model for the pricing of American-style options.





Options, the most flexible financial instrument that exists today, provide unique investment opportunities to knowledgeable traders on a regular basis. However, the entire options arena can be a very complex and confusing place in which to venture, especially for the novice trader. The primary reason for this complexity is the fact that options trading is a multidimensional process; and each dimension needs to be understood in order to trade successfully.

Prior to initiating an options position, there are three main issues to consider: direction, duration, and magnitude. Direction refers to whether the underlying security will move up, down, or sideways. Duration refers to how long it will take for the anticipated move to take place. Magnitude refers to how big the subsequent move will be. In order to make a profit, the options trader must be correct in all three of these categories. This is the primary reason that many people lose money when trading options. They do not accurately understand the three dimensions of an options position.

The first step in taking your options trading to another level is to understand and comprehend the interrelation of direction, duration, and magnitude. Additionally, the trader must use these three different variables in order to provide an edge in the market. It is imperative to be able to combine and exploit these three variables in order to give yourself an advantage; otherwise your trading will become no more than an exercise in giving your money away to other traders.

Many times it is necessary to work with combinations of options in order to give yourself an edge in the market as opposed to just buying a call or a put. This is where understanding spreads, straddles, and various option combinations is helpful. There are a few general rules that I always follow when looking for and constructing option positions. The first is that when I am going to bet on the future direction of a security, I want to give myself enough time to be right. That means I will usually choose long-term equity anticipation securities (LEAPS) for directional trades. LEAPS is a name given to options with expiration dates further than ninemonths away. The second rule is in regard to magnitude or volatility.

When combining different options together, I want to be a seller of expensive options (high volatility) and a buyer of cheap options (low volatility). The third rule is that I want to make time my friend as opposed to my enemy by purchasing options that have plenty of time left to expiration and selling shorter-term options. This allows me to take advantage of the time decay characteristic of an option. These guidelines are a brief summary of the issues that need to be understood when building trades that give you a competitive edge in the market. To the beginner, these issues may seem complex and convoluted; but with a little bit of practice everything should become quite clear.

If you take the time to understand the concepts of direction, duration, and magnitude, you’ll soon be able to start experimenting with a variety of different options strategies. For example, if you want to be bullish on a particular stock, then you can take a longer-term perspective by placing a bull call spread using LEAPS. For shorter-term trades, you can take advantage of time decay by using credit spreads, calendar spreads, or butterfly strategies. Increased comprehension of these basic concepts will enable you to combine short- and long-term strategies together to help you become an even more proficient trader.

As you build experience as a trader, you will become more confident in your ability to make money. After a few successes, traders are more motivated to develop the perseverance necessary to stay with the winning trades and exit losing positions quickly. In the long run, you have a much better chance of becoming successful when you start by acquiring a solid foundation of the option basics. In addition, keep a journal of every trade you make—especially your paper trades—as a road map of where you’ve been and where you want to go on your journey to trading victory. Remember, patience and persistence are the keys to trading options successfully.