Factors Affecting The Price Of Options Essay

2210 Words Mar 14th, 2016 9 Pages
What are the factors affecting the prices of options? Explain the assumptions in the Black-Scholes model.
In order to understand the factors that affect the prices of options, we need to understand what options are and how they work. Options are derivative assets. According to a California-based company called Optionetics (website: www.optionetics.com), "options are the most versatile trading instruments ever invented". This means, that you aren 't limited to making a profit only when the market goes up, you can also make money when the market goes down or even sideways. Since options cost less than stock, they provide a high leverage approach to trading that can significantly limit the overall risk of a trade or provide additional income. When you are controlling 100 shares with one contract, it does not take much of a price movement to generate substantial profits.
There are two functions that options are used for: to speculate, which is a highly risky practice where the big money is made and lost; and to hedge in order to reduce the risk of holding an asset. The basic approach of hedging is to create a financial position in risk factors that are negatively correlated with the core value of the firm. For instance, a firm may hedge changes in their cash flow due to changes in interest rates or in currency values.
Options, just like other derivatives, are traded in the over-the-counter market (OTC) and on organized exchanges. Organized exchanges have a physical location…

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