Option Valuation Models

The chapter focuses on how options are priced, and may be skipped over by readers, who are more concerned with applications. At the same time, it is not intended to cover the more complex mathematics of option pricing. The chapter further illustrates that an option pricing model has to meet certain constraints, and moves on to demonstrate a key result, the put-call parity relationship. A simple option valuation model is developed using a one-step and then a three-step binomial tree, with the volatility of the underlying incorporated into the model. As more and more steps are added to the tree the option value converges on that calculated by the famous Black-Scholes option pricing model. This chapter highlights some of the simplifying assumptions made by the model, the circumstances in which they tend to break down, and discusses how option traders compensate for these problems in practice. In practice, the assumptions made by the model may not work very effectively in extreme markets. Traders can compensate for this by adjusting the implied volatility they use to price and trade options.