Pricing options
An option buyer has the right but not the obligation to exercise on the seller. The worst that
can happen to a buyer is the loss of the premium paid by him. His downside is limited to this
premium, but his upside is potentially unlimited. This optionality is precious and has a value,
which is expressed in terms of the option price. Just like in other free markets, it is the supply and
demand in the secondary market that drives the price of an option. On dates prior to 31 Dec 2000,
the "call option on Nifty expiring on 31 Dec 2000 with a strike of 1500" will trade at a price
that purely reflects supply and demand. There is a separate order book for each option which
generates its own price. The values shown in Table 7.1 are derived from a theoretical model,
namely the Black-Scholes option pricing model. If the secondary market prices deviate from
these values, it would imply the presence of arbitrage opportunities, which (we might expect)
would be swiftly exploited. But there is nothing innate in the market which forces the prices in
the table to come about.
There are various models which help us get close to the true price of an option. Most of these
are variants of the celebrated Black-Scholes model for pricing European options. Today most
Table 7.1 Option prices: some illustrative values
Option strike price
1400 1450 1500 1550 1600
Calls
1 mth 117 79 48 27 13
3 mth 154 119 90 67 48
Puts
1mth 8 19 38 66 102
3 mth 25 39 59 84 114
Assumptions: Nifty spot is 1500, Nifty
volatility is 25% annualized, interest rate
is 10%, Nifty dividend yield is 1.5%.
100 Pricing options
calculators and spread-sheets come with a built-in Black-Scholes options pricing formula so to
price o ...