Thursday, February 17, 2011

Options Trading In India - Part V

What are different pricing models for options?

The theoretical option pricing models are used by option traders for calculating the fair value of an option on the basis of the earlier mentioned influencing factors.
An option pricing model assists the trader in keeping the prices of calls & puts in proper numerical relationship to each other & helping the trader make bids & offer quickly. The two most popular option pricing models are:

Black Scholes Model which assumes that percentage change in the price of underlying follows a normal distribution.

Binomial Model which assumes that percentage change in price of the underlying follows a binomial distribution.

Who decides on the premium paid on options & how is it calculated?

Options Premium is not fixed by the Exchange. The fair value/ theoretical price of an option can be known with the help of pricing models and then depending on market conditions the price is determined by competitive bids and offers in the trading environment.

An option's premium / price is the sum of Intrinsic value and time value. If the price of the underlying stock is held constant, the intrinsic value portion of an option premium will remain constant as well. Therefore, any change in the price of the option will be entirely due to a change in the option's time value.

The time value component of the option premium can change in response to a change in the volatility of the underlying, the time to expiry, interest rate fluctuations, dividend payments and to the immediate effect of supply and demand for both the underlying and its option.
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