I usually trade in equity spot market, but I wish to enhance my trading skills to make more money through trading in the options market and I can see there is a call option on GOPRO Inc. with premium of $4. Here, if I want to evaluate whether the option is overvalued, undervalued or correctly priced, I should be aware of option valuation. It is very important to grab the concept of valuation for option trading.
Option valuation in brief:-
Valuation of Options
Your friends might have had success beating the markets by trading stocks in a disciplined manner by anticipating a nice move either up or down, resulting into huge profits. Many traders have also gained the confidence to make money in the stock market by identifying one or two good stocks that may make a big move soon. But, if you are not aware of how to take advantage of that movement, you might find yourself to be left out in the dust. If this sounds familiar to you, then maybe it's time to consider using options to play your next move.
This session will enable you to gain deep insights into the methodology behind option pricing and also some simple factors that you must consider, if you plan to trade options to take advantage of stock movements.
Before venturing into the world of options, you need to understand the factors determining the price of an option. The primary drivers of the price of an option are:
- Intrinsic Value
- Time to Expiration
- Interest Rates
- Cash Dividends Paid
Option Pricing Models
Those who trade in options make use of some option pricing models to know the current theoretical value of an option. These models make use of certain variables mentioned above to compute its theoretical value at a certain point in time. These variables will fluctuate over the life of the option and its value will accordingly reset itself to reflect those changes.
Many option trading platforms will provide you with up to date option price modeling values that option traders can monitor the changing risk profile of option positions and help them in formulating decisions.
The popular models used in option pricing are:
- Risk Neutral Model
- Binomial Model
- The Noble prize winning, Black Scholes Merton Model
All the above option pricing models should follow the put call parity. If there is any pricing model that produces option prices which violates the put call parity, is flawed, else arbitrage opportunities would come into play. To understand all about the Put Call Parity, follow the brief on this relationship below:
Replication Of Call And Put Option
In the previous sessions, we discussed at length about the mechanics of options. We learnt the underlying logic behind trading call and put options. In this session, we will look at yet another captivating reality arising out of option markets i.e. put call parity relationship.
By gaining insights into this relationship, you will be able to better comprehend:
- The mechanics that professional traders use to value options
- How all option values at all available strike prices and expirations on the same underlying are related.
- How supply and demand impact option prices.
The basic idea behind put call parity (as identified by Stoll in 1969) is that option trading positions with similar risk profiles must end up with the same profit/loss upon expiration such that no arbitrage opportunities exist.
The objective behind creating a replicating portfolio is to use a combination of risk free borrowing/lending along with the underlying asset to create exactly same cash flows as the option being valued.
However, there are some drawbacks in the usage of Put Call parity:
It generally applies to European options which can be exercised only at the time of expiration. American options can be exercised early (before time to expiration) which may result in profit opportunities that lies beyond the put call parity relationship.