Advanced Option Pricing Models by Jeffrey Owen Katz

By Jeffrey Owen Katz

Complicated choice Pricing types information particular stipulations below which present alternative pricing versions fail to supply actual fee estimates after which indicates choice investors the way to build greater versions for greater pricing in a much wider variety of marketplace stipulations. Model-building steps conceal thoughts pricing lower than conditional or marginal distributions, utilizing polynomial approximations and “curve fitting,” and compensating for suggest reversion. The authors additionally increase powerful prototype versions that may be positioned to fast use, with real-time examples of the types in motion.

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From the options seller’s point of view, being short a call means having given someone the right to purchase from him or her the underlying security at the strike price of the option, regardless 19 Copyright © 2005 by Scientific Consultant Services, Inc. Click here for terms of use. 20 CHAPTER 1 of that security’s current market value. If and when this right is exercised, the trader who is short the option is said to have been assigned. While a call gives its holder the right to buy the underlying security, a put gives the trader the right to sell the underlying security at the strike price of the option.

An option pricing model, if not already clear from the context, is a mathematical algorithm or formula by which the theoretical fair value of an option may be calculated. Such a model, naturally, bases its calculations on certain assumptions regarding the nature of fair value, the behavior of price movements in the underlying security, and the effects of a variety of factors that are known to influence option prices. A Review of Options Basics 29 An option pricing model is necessary, not only for estimating fair value, but also for calculating several other useful items.

These charts show how options theoretically respond to the various factors discussed earlier, such as life remaining in the option, volatility, and moneyness. 34 CHAPTER 1 Response charts are useful for visualizing the impact of various factors on an option’s premium and the related Greeks. Figure 1–1 depicts the relationship between call option prices, stock prices, and time remaining before expiration. Annotations on the chart delineate the two kinds of value that make up an option’s premium: intrinsic value and time value.

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