Options 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 …show more content…
Everything else remaining equal, we shall consider the effect of the expiration date. Both put and call “American” options become more valuable (or, at least, do not decrease in value) as the time to expiration increases. This makes sense when you compare the call owners of the long-life and the short-life options. Clearly the long-life option holder has more open opportunities before the option expires, therefore, the long-life American option must always be worth at least as much as the shirt-life option. Time to expiration date effect on the “European” put and call options prices is not that straightforward, that is why I will not be making assumptions in this