An Introduction to The Valuation of Options

The value of an option has two basic elements and these are intrinsic value and time value. Embedded value, also called intrinsic value is the option holder’s right to obtain value, through the direct purchase of stock rather than stock returns achieved. Plus time value according to two elements: time value and volatility of the currency value.

Since the values of option contracts rely on several variables besides the value of the underlying asset, their valuation is complex. There are a number of pricing models employed, and these include Black-Scholes model, binomial options pricing model, Monte Carlo option model and the finite difference method for option pricing.

Fluctuations in the value of the option holder’s corresponding stock varies from the option value in profit or loss at the same time up to the stock option value rather than the possibility of full market value loss. For example, the volatility of the stock is the previous or expected amount of future stock price volatility.

In general, the greater the volatility of the stock, the greater the potential benefits, that is, the risk reward. The volatility of the stock according to the statistical distribution is usually measured in standard deviation.

From a statistical point of view, if the first year bears the expected volatility of 25% the end price will be 25% of the shares, and the probability of change typically hovers above 50%.

The option pricing model operates by considering the expected stock price volatility to assume the statistical distribution of future stock prices, thus deciphering the estimated future price possibilities.

The Black-Scholes model assumes stock prices follow log normal distribution, and that small fluctuations in stock price volatility are more likely. Hence, the greater the price increase the greater the likelihood of a higher rate.

A sharp decrease in the cost of stock options reflected by the present value of the limit, although significant increase in the profit share is unlimited. And volatility of stock options on the stocks are more likely to lead to greater profits than the small fluctuations in the options.

Option holders do not pay for the line right before the exercise price, and over time, the stock price may rise resulting in additional embedded value. In principle, all options have time value prior to maturity, risk factors and other conditions being equal, the longer the time to expiration (time value).

At the right time in the waiting line, an option holder can first invest in other areas such as risk-free bonds (T-bills). The higher the time value, the more practical it is to delay the payment of the exercise price.

 

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