Pricing Models

Options are affected by many different market forces. Most options traders have, at one time or another, found themselves asking, "Among all the different trading months, strike prices, and trading strategies, how do I identify an option position that represents a profit opportunity?" Option pricing models enable you to identify potentially profitable options positions.

The Basic Optionalysis package uses the Black Scholes options pricing model.

The Advanced Optionalysis package gives you a choice of using the Black Scholes, Binomial, or Whaley pricing models.

The value of an option is determined by the following variables.

Strike Price

An option’s strike price is easy to identify. Look at the symbol and you can identify the strike price. For example, consider the following symbol:

SPU445C

This is the symbol for the Standard & Poors 500 Index (SP) September (U) 445 strike price (445) call option (C). Knowing the strike price (445) is important to evaluating the value of a position involving the option. The definition of strike price is the price an underlying instrument will be bought or sold if the option is exercised.

Time to Expiration

You can also get an idea of the time to expiration by looking at an option symbol. In the example above, the month code (U) indicates the option expires in September. The actual expiration date is not evident in the option symbol. However, Aspen Graphics uses the symbol’s month code, the INFO.TXT file, and a set of option expiration rules to calculate the amount of time to expiration.

Options traders usually measure time to expiration in calendar days. Calendar days are days on which the interest rate applies. Time to expiration is calculated using a seven-day week. Weekends and observed holidays are included. With Aspen Graphics, not only can you choose calendar days, but also business days (a five-day week), or trading days (a five-day week less observed holidays) to figure time to expiration.

Underlying Price

The price of the underlying instrument is also easy to identify. The last price of an underlying instrument is normally thought a good indication of its price. However, some traders use the relationship of bid and ask prices to the last price to determine the underlying instrument’s price. For example, suppose you are looking at an instrument with a last price of 32.04. The bid is 32.04, and the ask is 32.08. The individual who values the instrument on the last price will use the price of 32.04. The individual who values the instrument on the relationship between the last price and the bid and ask prices will use a price of 32.06 or 32.08. With Aspen Graphics, you can not only use bids, asks, or bid ask mid-points, but a variety of other prices as well.

Interest Rates

Interest rates affect the carrying cost of an option position. Like measuring time to expiration, most individuals calculate interest rate costs over weekends and holidays.

Volatility

Volatility is what enables you assign a probability to the infinite number of prices an underlying instrument can have at expiration. Volatility measures the degree to which the price of the underlying instrument fluctuates over time.

By default, Aspen Graphics uses the implied volatility of the at-the-money strike to calculate theoretical values. If you want to use a value other than the at-the-money strike, you change the volatility type in the Parameters menu from implied to database, and then assign a volatility to the instrument using the .MODIFY command.