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Option Pricing Theory

Option Pricing Theory

The most used models  are the Black-Scholes model and the binomial model. Both theories on options pricing have margins for error because their values are derived from other assets, usually the price of a company’s common/share stock.

Binomial option pricing model

The binomial option pricing model assumes a perfectly efficient market. Under this assumption, it is able to provide a mathematical valuation of an option at each point in the timeframe specified. The binomial model takes a risk-neutral approach to valuation and assumes that underlying security prices can only either decrease or increase  with time until the option expires worthless.The model reduces possibilities of price changes, and removes the possibility for arbitrage.

The binomial option pricing model uses an iterative procedure, allowing for the specification of nodes, or points in time, during the time span between the valuation date and the option’s expiration date.

The Black–Scholes formula

The Black–Scholes formula has only one parameter that cannot be observed in the market: the average future volatility of the underlying asset.

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