30 years: Financial markets trader
The Black-Scholes Merton option pricing model is the Nobel Prize winning formula that is used as the basis of pricing options. In this video, Abdulla will discuss option pricing without Black-Scholes and in doing so it will provide hints to understanding the more complex area of option Greeks which will be covered in the second video on this topic.
The Black-Scholes Merton option pricing model is the Nobel Prize winning formula that is used as the basis of pricing options. In this video, Abdulla will discuss option pricing without Black-Scholes and in doing so it will provide hints to understanding the more complex area of option Greeks which will be covered in the second video on this topic.
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5 mins 8 secs
Pricing an option requires a range of outcomes with the associated probability for each outcome, in other words, we need to make an assumption regarding the future probability distribution. We can work out the total probability weighted payoff based on our assumptions, which when discounted gives us the option price.
Key learning objectives:
Outline the Black-Scholes formula
Describe an option payoff
Understand how we price an option
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We would only exercise an option if it had a positive value at expiry, a positive payoff, irrespective of the premium that we originally paid for it.
For a call option, the payoff would be the maximum of the spot at expiry minus the strike, or zero. For a put option, it would be the maximum of the strike minus the spot at expiry, or zero. For example, if we take a strike of 500 and the expiry price of 520, the call would be exercised as it would have a payoff of 20. Whereas the put would be abandoned as the payoff would be zero, the maximum of -20 or zero.
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