It’s been a while that I have been writing to you about different topics relating to stock market and alternatives in particular. But in the process of being more relevant to groceries I probably missed out one important basic point to discuss and that is option pricing.

Option pricing is a very critical piece in the overall programme of options trading. There are multiple methods of option pricing, like Black- Scholes, Cox Ross Rubenstein& Binomial Model. However, the most accepted and the one that Indian business follow is the Black- Scholes( BS) model. This prototype was developed by Nobel laureates Fischer Black, Myron Scholes and Robert Merton.

Now, any option toll is a combination of two parts: Intrinsic Value+ Extrinsic Value/ Time Value. So, if you brace a Nifty 11900 Call, which is currently quoting at Rs 80/ – and the present underlying expenditure is 11950. The intrinsic significance is Rs 50/ – rest of the price is the extrinsic value.

However, in case of At The Money( ATM) and Out the Money( OTM) alternatives there is no intrinsic value. All the expenditure is Extrinsic Value simply. The mannequin helps in giving a compensate premium to the extrinsic value.

Option rate is a function of five ingredients 😛 TAGEND

Spot rate, Strike price, Time to Expiry, Volatility and Interest Rate.

So, given the fact that all the factors other than Volatility are known, volatility or suggested volatility becomes the most crucial input for option pricing.

Any model is based on assumption. So, in-case of BS mannequins as well there are certain acceptances fixed. They are 😛 TAGEND

The capital tolls are log normally given The short selling of certificates with full operation of proceeds is granted There are no business penalties or taxes. All defences are perfectly divisible There are no dividends( this assumption was modified later on) There is no probability less arbitrage possibilities Security trading is continuous The danger free pace of interest is constant for all maturities and for all participants.

The beliefs of a example generally become its limitations. The limits here are 😛 TAGEND

the assumption of naturalnes lead to underestimation of extreme moves, producing tail peril. the assumption of instant, cost-less trading, provide liquidity peril, the assumption of a stationary process, furnish volatility jeopardy. the assumption of continual occasion and continuous trading.

However, with all the above limiteds as well it provides the best pricing possible. The pricing is so precise that there is hardly any arbitrage there. This conception is announced ” Put- Call Parity “. In event of any mispricing, arbitrage musicians immediately rectify it.

For instance, if we make Nifty December 12000 strike. The Call is quoting at Rs 36/ – and the Put is quoting at Rs 108/. December futures are paraphrasing at 11950. As, the frame order parity superintendent, Put Price+ Futures Price= Call Price+ Strike Price 108+ 11950 [?] 12000 +36

12058 [?] 12036

Hence, adjusted for transaction prices there used to be no arbitrage available.

So, just as the science for any other method of valuation is well researched and admitted, so is in the case alternatives. The finer and better that one premiums it the very best the evaluate in the trade.

Happy Trading !!!

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