Well, this wouldn’t be much of a derivatives blog without a discussion of, and pricer for, vanilla options. ‘Vanilla’ options are what quants call the basic call and put options that really are the bread-and-butter of what we do (there are good descriptions all over the web of what these are, and I’m not going to go into too much detail here).
A call(put) option on an asset is the right to buy(sell) that asset at a certain strike price, K, at a certain time, T. Usually, the underlying asset will be an asset that has a quoted market spot price, S, that it can be readily traded at. If at time T the price S is more than K, then the call option will have some value, as the asset can be bought at K and sold at S for a profit of (S – K). The put will be worthless, since the right to sell the asset at K isn’t much good if you can readily sell it on the market for a higher price S anyway! If the spot price S is below K, then the situation is reversed.
So calculating the price of the option at the expiry time is straight-forward. The question is, what is the price before this time? The answer is given by the famous Black-Scholes equation, and I’ve implemented a version in the pricer section for you to play with here: Vanilla Pricer. Clearly, before time T we don’t know what the stock price will be at time T. However, we might have some idea of what it’s probability distribution will look like. The amazing thing about option prices is that (within certain approximations) they depend only on the variance of this distribution, and not its expected value – no matter how fast we think the stock will grow, the option value is determined only by the spread of values. The more spread, the more valuable the option – because options have positive values for high terminal S, and losses are capped at zero for low terminal S, they are move valuable if there is a widespread set of outcomes possible.
What’s even more amazing is that we can get information the other way round – if we don’t know how the spot price S is going to end up, but we do have access to a market where options are being liquidly traded, we can IMPLY the terminal spot distribution from how these prices vary with strike! This is a really rich area of study and can be approached from lots of different angles, I’ll be going over some of this fairly slowly and in no particular order in the coming months.