Option Pricing in General

This chapter presents several ways of valuing an option price, that will imply how to model and to what extent its time value can be computed for a given volatility and time to maturity. The chapter also presents the three major option pricing models used by practitioners. They all pursue the same objective of modeling in a more or less realistic way how the underlying spot price will move over time, to compute what should be the option fair/theoretical price accordingly. The Black—Scholes formula is applicable to European options only, and provided the underlying financial instrument offers no return during the lifetime of the option. Monte Carlo simulation method proves useful for several second-generation options, with a complex payoff. Option pricing sensitivities are essential, mainly for options market makers, who trade options not for a particular objective, of hedging or speculation.