CHAPTER 4

Option Pricing Models and Implied Volatility

There are a nearly infinite number of variables we could analyze in trying to determine what an option is worth. We would look at the exercise price and whether it’s a call or a put. We’d certainly consider the expiration date, but we could also examine the fundamentals of the underlying stock, including its competitive position in its industry. We could examine its balance sheet, including cash on hand and accounts receivable. We could look at the stock’s chart over time to find important technical levels. We could look at the medical history of the CEO to try and divine if he’s likely to drop dead of a heart attack soon. Even if we could figure the odds of such a heart attack, we’d then have to figure out whether such a change in leadership would be a good thing (Swing-for-the-Fences Freddy from Company B) or a bad thing (Steady Eddie from Company A). The result would be so much analysis that we’d experience paralysis.

Instead of looking at everything, we might look at fewer inputs, just enough inputs to help us make some decisions. And since all the fundamental, technical, and even medical information is supposed to help us understand and measure risk, we could use a single proxy for risk. As we discussed in the Chapter 3, that risk measure is volatility.

IT’S AN OPTION PRICING MODEL, NOT AN EQUATION FOR OPTION VALUES

What do we have when we reduce the size and scope of a problem so that solving it becomes manageable? We ...

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