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Option Premiums- Introduction

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Option Premiums

Introduction
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 formul…