Guide to Option Pricing Formulas

A guide to option pricing formulas is important for traders and investors to have the best chance at reducing risks and maximizing forecasting. Of course, no guide to option pricing formulas will work if they are not implemented correctly and the limitations of each pricing formula are not evaluated and accommodated.

Guide to Option Pricing Formulas-Types

There are various types of option pricing formulas that any guide to option pricing formulas should include. For example, the binomial tree method that is referred to as the Monte Carlo pricing formula is based on a derivate pricing theory. Others include the Black and Scholes, Ross and Cox, as well as others.

Guide to Option Pricing Formulas-Limitations of Monte Carlo

There are no discount rates or expected returns that are realistic with the Monte Carlo formula. The problem with formulas that have risk free rates equal to their expected return is that there are no investors that are immune to risk. When used correctly, however, the prices for options can be accurate.

Guide to Option Pricing Formulas-Limitations of Black and Scholes

The Black and Scholes pricing formula is considered one of the most consistent and accurate for traders to use. However, it does have limitations as well because it is not completely based in realty. For example, it does not include commissions in the pricing model. This differential equations approach works well for traders who know its limitations and are capable of using the formula to their benefit. Inexperienced traders blindly following the results of the Black and Scholes formula will find themselves in dangerous waters.

Guide to Option Pricing Formulas-Limitations of Cox and Ross

The Cox and Ross formula deal with risk neutral valuation. The resulting technique was using binomial trees. In complete markets this model is most popular because it deals with derivatives. The risk neutral valuation can be limiting, however, because risk is inherent in options trading and must be accommodated for by traders and investors using this formula.

Guide to Option Pricing Formulas-Conclusion

The most important thing for traders and investors is to know what formula to use. The type of market is important, whether it is a bear or a bull, as well as whether the options are European or American. New traders blindly applying a formula will increase their risk levels substantially. Traders and investors should be well aware of what each model s limitations are as well as when to use specific models.