Investments glossary

Option Pricing Theory

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Quotes of the day:

Those noble men who falsehood dread In wealth and glory ever grow, As flames with greater brightness glow With oil in ceaseless flow when fed.

— Sanskrit Proverb

Option pricing theory uses variables (stock price, exercise price, volatility, interest rate, time to expiration) to theoretically value an option. Essentially, it provides an estimation of an option’s fair value which traders incorporate into their strategies to maximize profits. Some commonly used models to value options are Black-Scholes, binomial option pricing, and Monte-Carlo simulation. These theories have wide margins for error due to deriving their values from other assets, usually the price of a company’s common stock.

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