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OptionPricingModelsandthe"Greeks"

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BlackScholes
BinomialModel
OtherModels
TheDelta
Other"Greeks"

PricingModelsUsed
TheBlackScholesmodelandtheCox,
RossandRubinsteinbinomialmodelare
theprimarypricingmodelsusedbythe
softwareavailablefromthissite(Finance
AddinforExcel,theOptionsStrategy
EvaluationTool,andtheonlinepricing
calculators.)
Bothmodelsarebasedonthesame
theoreticalfoundationsandassumptions
(suchasthegeometricBrownianmotion
theoryofstockpricebehaviourandriskneutralvaluation).However,therearealsosome
someimportantdifferencesbetweenthetwomodelsandthesearehighlightedbelow.
Seealso:
FinanceAddinforExcel:Optionpricingfunctions.

OptionsAnalysisSoftware:Toolsforoptionsstrategyevaluationandmore.

OnlineCalculators:Optionvaluationandprobabilitycalculations.

TheBlackScholesModel
TheBlackScholesmodelisusedtocalculateatheoreticalcallprice(ignoringdividendspaid
duringthelifeoftheoption)usingthefivekeydeterminantsofanoption'sprice:stockprice,
strikeprice,volatility,timetoexpiration,andshortterm(riskfree)interestrate.
Theoriginalformulaforcalculatingthetheoreticaloptionprice(OP)isasfollows:

Where:

Thevariablesare:
S=stockprice
X=strikeprice
t=timeremaininguntilexpiration,expressedasapercentofayear
r=currentcontinuouslycompoundedriskfreeinterestrate
v=annualvolatilityofstockprice(thestandarddeviationoftheshorttermreturnsoverone
year).Seebelowforhowtoestimatevolatility.
ln=naturallogarithm
N(x)=standardnormalcumulativedistributionfunction
e=theexponentialfunction

Lognormaldistributionbuthowrealistic?
Themodelisbasedonanormaldistributionofunderlyingassetreturnswhichisthesame
thingassayingthattheunderlyingassetpricesthemselvesarelognormallydistributed.A
lognormaldistributionhasalongerrighttailcomparedwithanormal,orbellshaped,
distribution.Thelognormaldistributionallowsforastockpricedistributionofbetweenzeroand
infinity(ienonegativeprices)andhasanupwardbias(representingthefactthatastockprice
canonlydrop100%butcanrisebymorethan100%).
Inpracticeunderlyingassetpricedistributionsoftendepartsignificantlyfromthelognormal.
Forexamplehistoricaldistributionsofunderlyingassetreturnsoftenhavefatterleftandright
tailsthananormaldistributionindicatingthatdramaticmarketmovesoccurwithgreater

frequencythanwouldbepredictedbyanormaldistributionofreturnsiemoreveryhigh
returnsandmoreverylowreturns.
Acorollaryofthisisthevolatilitysmilethewayinwhichatthemoneyoptionsoftenhavea
lowervolatilitythandeeplyoutofthemoneyoptionsordeeplyinthemoneyoptions.
TheFinanceAddinforExcelwhichcanbedownloadedfromthissitecontainsthreesetsof
toolsfordealingwithnonlognormallydistributedassetpricesandthevolatilitysmile:
ModifiedBlackScholesandbinomialpricing(usingimpliedbinomialtrees)forEuropean
andAmericanoptionpricingwithnonlognormaldistributions.Thesemodelscanbe
usedtoseetheimpactonoptionpricesofnonlognormalpricedistributions(as
measuredbycoefficentsofskewness(symmetry)andkurtosis(fatnessofdistribution
tailsandheightofpeaks)),andtocalculateandplotthevolatilitysmileimpliedbythese
distributions.

Measuringthedegreetowhichhistoricalassetpricedistributionsdivergefromthe
lognormal(asmeasuredbycoefficentsofskewnessandkurtosis).

Plottingnonlognormaldistributioncurvesforspecifiedcoefficientsofskewnessand
Kurtosis(aswellasvolatilityetc)toseehowtheydifferfromthelognormal.

Inadditiontousingtheaddinyoucanusetheonlinestockpricedistributioncalculatorto
examinethesensitivityoftheshapeofthelognormalstockpricedistributioncurvetochanges
intime,volatility,andexpectedgrowthrates.Andyoucanalsousetheonlinestockprice
probabilitycalculatortolookattheprobabilitiesofstockpricesexceedingupperandlower
boundarypricesbothattheendofaspecifiednumberofdaysandatanytimeduringthe
period.

Volatilityimpliedorhistorical?
Thisisthemostcriticalparameterforoptionpricingoptionpricesareverysensitiveto
changesinvolatility.Volatilityhowevercannotbedirectlyobservedandmustbeestimated.
Whilstimpliedvolatilitythevolatilityoftheoptionimpliedbycurrentmarketpricesis
commonlyusedtheargumentthatthisisthe"best"estimateissomewhatcircular.Skilled
optionstraderswillnotrelysolelyonimpliedvolatilitybutwilllookbehindtheestimatestosee
whetherornottheyarehigherorlowerthanyouwouldexpectfromhistoricalandcurrent
volatilities,andhencewhetheroptionsaremoreexpensiveorcheaperthanperhapsthey
shouldbe.
It'saslightoversimplification,butbasicallyimpliedvolatilitywillgiveyouthepriceofanoption
historicalvolatilitywillgiveyouanindicationofitsvalue.It'simportanttounderstandboth.For
instance,ifyourforecastofvolatilitybasedonhistoricalpricesisgreaterthancurrentimplied
volatility(optionsundervalued)youmightwanttobuyastraddleifyourhistoricalforecastis
lessthanimpliedvolatilityyoumightwanttosellastraddle.
Thissitecontainsoneofthemostcomprehensivesetsoftoolsavailableforgettingahandle
onvolatility.ThetoolsincludeanHistoricVolatilityCalculator(whichautomaticallyextracts
historicpricesfromtheweb,andcalculatesandgraphsvolatility),anImpliedVolatility
Calculator(whichretrievesandcalculatesimpliedvolatilityforanentireoptionchain),andan
ExcelAddin(forthosewholiketobuildtheirownExcelapplications).Thevolatilityfunctionsin
theaddininclude:
Impliedvolatilitycalculation(AmericanandEuropeanoptions,withandwithout
dividends).

Equallyweightedhistoricalvolatilityestimationusinghistoricalprices:oneormore
ofhighlow,closing,andopenprices.Allthepricedatarequiredareavailableatno
chargeatsitessuchasYahoo.

ExponentiallyweightedhistoricalvolatilityestimationusingtheEWMA
(exponentiallyweightedmovingaverage)modelortheGARCHmodel.Thesemodels
givegreateremphasistomorerecentprices.

VolatilityforecastingusingtheGARCHmodel,whichletsyouseehowvolatilityis
likelytomoveinthefuture.Acommonapplicationofthisistocreatevolatilityterm
structuresfortheweeksormonthsaheadtoanswerquestionslike"whatvolatility
shouldIuseforpricinganoptionwithalifeofthreemonths?".

Theimpliedvolatility,historicalvolatility,andforecastvolatilitytoolsarecomplementary.With
volatilitybeingsuchacriticalfactoragoodoptionstraderwilluseallthreesetsoftoolstohelp
formaviewaboutthevolatilitytouseinpricingoptions.
SeetheFinanceAddinforExcelandVolatilityFAQspages,HistoricVolatilityCalculatorpage,
ImpliedVolatilityCalculatorpage,andtheonlinedemosformoreinformation.

Riskneutralvaluationdoestheexpectedstockreturnmatter?
Unlikevolatility,whichisallimportantfordeterminingthefairvalueofanoption,viewsabout
thefuturedirectionofanunderlyingasset(iewhetheryouthinkitwillgoupordowninthe
futureandbyhowmuch)arecompletelyirrelevant.
Significantly,theexpectedrateofreturnofthestock(whichwouldincorporateriskpreferences
ofinvestorsasanequityriskpremium)isnotoneofthevariablesintheBlackScholesmodel
(oranyothermodelforoptionvaluation).Theimportantimplicationisthatthevalueofan
optioniscompletelyindependentoftheexpectedgrowthoftheunderlyingasset(andis
thereforeriskneutral).
Thus,whileanytwoinvestorsmaystronglydisagreeontherateofreturntheyexpectona
stocktheywill,givenagreementtotheassumptionsofvolatilityandtheriskfreerate,always
agreeonthefairvalueoftheoptiononthatunderlyingasset.
Thefactthatapredictionofthefuturepriceoftheunderlyingassetisnotnecessarytovalue
anoptionmayappeartobecounterintuitive,butitcaneasilybeshowntobecorrect.
DynamicallyhedgingacallusingunderlyingassetpricesgeneratedfromMonteCarlo
simulationisaparticularlyconvincingwayofdemonstratingthis.Irrespectiveofthe
assumptionsregardingstockpricegrowthbuiltintotheMonteCarlosimulationthecostof
hedgingacall(iedynamicallymaintainingadeltaneutralpositionbybuying&sellingthe
underlyingasset)willalwaysbethesame,andwillbeveryclosetotheBlackScholesvalue.
(TheFinanceAddinforExcelavailablefromthissitecontainsaMonteCarlosimulation
componentwhichcanbeusedforthispurpose.)
Puttingitanotherway,whetherthestockpricerisesorfallsafter,eg,writingacall,itwill
alwayscostthesame(providingvolatilityremainsconstant)todynamicallyhedgethecalland
thiscost,whendiscountedbacktopresentvalueattheriskfreerate,isveryclosetothe
BlackScholesvalue.
WhichishardlysurprisinggiventhattheBlackScholespriceisnothingmorethantheamount
anoptionwriterwouldrequireascompensationforwritingacallandcompletelyhedgingthe
risk.Theimportantpointisthatthehedger'sviewaboutfuturestockpricesisirrelevant.
Thiskeyconceptunderlyingthevaluationofallderivativesthatfactthatthepriceofan
optionisindependentoftheriskpreferencesofinvestorsiscalledriskneutralvaluation.It
meansthatallderivativescanbevaluedbyassumingthatthereturnfromtheirunderlying
assetsistheriskfreerate.

Advantages&Limitations
Advantage:ThemainadvantageoftheBlackScholesmodelisspeeditletsyoucalculatea
verylargenumberofoptionpricesinaveryshorttime.
Limitation:TheBlackScholesmodelhasonemajorlimitation:itcannotbeusedtoaccurately
priceoptionswithanAmericanstyleexerciseasitonlycalculatestheoptionpriceatonepoint
intimeatexpiration.Itdoesnotconsiderthestepsalongthewaywheretherecouldbethe
possibilityofearlyexerciseofanAmericanoption.
AsallexchangetradedequityoptionshaveAmericanstyleexercise(ietheycanbeexercised
atanytimeasopposedtoEuropeanoptionswhichcanonlybeexercisedatexpiration)thisis
asignificantlimitation.
TheexceptiontothisisanAmericancallonanondividendpayingasset.Inthiscasethecall
isalwaysworththesameasitsEuropeanequivalentasthereisneveranyadvantagein
exercisingearly.
VariousadjustmentsaresometimesmadetotheBlackScholespricetoenableitto
approximateAmericanoptionprices(egtheFischerBlackPseudoAmericanmethod)but
theseonlyworkwellwithincertainlimitsandtheydon'treallyworkwellforputs.

TheBinomialModel
Thebinomialmodelbreaksdownthetimetoexpirationintopotentiallyaverylargenumberof
timeintervals,orsteps.Atreeofstockpricesisinitiallyproducedworkingforwardfromthe
presenttoexpiration.Ateachstepitisassumedthatthestockpricewillmoveupordownby
anamountcalculatedusingvolatilityandtimetoexpiration.Thisproducesabinomial
distribution,orrecombiningtree,ofunderlyingstockprices.Thetreerepresentsallthepossible
pathsthatthestockpricecouldtakeduringthelifeoftheoption.
Attheendofthetreeieatexpirationoftheoptionalltheterminaloptionpricesforeachof
thefinalpossiblestockpricesareknownastheysimplyequaltheirintrinsicvalues.
Nexttheoptionpricesateachstepofthetreearecalculatedworkingbackfromexpirationto
thepresent.Theoptionpricesateachstepareusedtoderivetheoptionpricesatthenext
stepofthetreeusingriskneutralvaluationbasedontheprobabilitiesofthestockprices
movingupordown,theriskfreerateandthetimeintervalofeachstep.Anyadjustmentsto

stockprices(atanexdividenddate)oroptionprices(asaresultofearlyexerciseofAmerican
options)areworkedintothecalculationsattherequiredpointintime.Atthetopofthetreeyou
areleftwithoneoptionprice.
Togetafeelforhowthebinomialmodelworksyoucanusetheonlinebinomialtree
calculators:eitherusingtheoriginalCox,Ross,&Rubinsteintreeortheequalprobabilities
tree,whichproducesequallyaccurateresultswhileovercomingsomeofthelimitationsofthe
CRRmodel.ThecalculatorsletyoucalculateEuropeanorAmericanoptionpricesand
displaygraphicallythetreestructureusedinthecalculation.Dividendscanbespecifiedas
beingdiscreteorasanannualyield,andpointsatwhichearlyexerciseisassumedfor
Americanoptionsarehighlighted.

Advantages&Limitations
Advantage:ThebigadvantagethebinomialmodelhasovertheBlackScholesmodelisthatit
canbeusedtoaccuratelypriceAmericanoptions.Thisisbecausewiththebinomialmodel
it'spossibletocheckateverypointinanoption'slife(ieateverystepofthebinomialtree)for
thepossibilityofearlyexercise(egwhere,duetoegadividend,oraputbeingdeeplyinthe
moneytheoptionpriceatthatpointislessthanitsintrinsicvalue).
Whereanearlyexercisepointisfounditisassumedthattheoptionholderwouldelectto
exercise,andtheoptionpricecanbeadjustedtoequaltheintrinsicvalueatthatpoint.This
thenflowsintothecalculationshigherupthetreeandsoon.
Theonlinebinomialtreegraphicaloptioncalculatorhighlightsthosepointsinthetreestructure
whereearlyexercisewouldhavehavecausedanAmericanpricetodifferfromaEuropean
price.
Thebinomialmodelbasicallysolvesthesameequation,usingacomputationalprocedurethat
theBlackScholesmodelsolvesusingananalyticapproachandindoingsoprovides
opportunitiesalongthewaytocheckforearlyexerciseforAmericanoptions.
Limitation:Themainlimitationofthebinomialmodelisitsrelativelyslowspeed.It'sgreatfor
halfadozencalculationsatatimebutevenwithtoday'sfastestPCsit'snotapracticalsolution
forthecalculationofthousandsofpricesinafewseconds.

RelationshiptotheBlackScholesmodel
Thesameunderlyingassumptionsregardingstockpricesunderpinboththebinomialand
BlackScholesmodels:thatstockpricesfollowastochasticprocessdescribedbygeometric
brownianmotion.Asaresult,forEuropeanoptions,thebinomialmodelconvergesonthe
BlackScholesformulaasthenumberofbinomialcalculationstepsincreases.InfacttheBlack
ScholesmodelforEuropeanoptionsisreallyaspecialcaseofthebinomialmodelwherethe
numberofbinomialstepsisinfinite.Inotherwords,thebinomialmodelprovidesdiscrete
approximationstothecontinuousprocessunderlyingtheBlackScholesmodel.
WhilsttheCox,Ross&RubinsteinbinomialmodelandtheBlackScholesmodelultimately
convergeasthenumberoftimestepsgetsinfinitelylargeandthelengthofeachstepgets
infinitesimallysmallthisconvergence,exceptforatthemoneyoptions,isanythingbutsmooth
oruniform.ToexaminethewayinwhichthetwomodelsconvergeseetheonlineBlack
Scholes/Binomialconvergenceanalysiscalculator.Thisletsyouexaminegraphicallyhow
convergencechangesasthenumberofstepsinthebinomialcalculationincreasesaswellas
theimpactonconvergenceofchangestothestrikeprice,stockprice,timetoexpiration,
volatilityandriskfreeinterestrate.

OtherModelsusedbytheSoftwareforAmericanOptions
Forrapidcalculationofalargenumberofprices,analyticmodels,likeBlackScholes,arethe
onlypracticaloptiononeventhefastestPCs.However,thepricingofAmericanoptions(other
thancallsonnondividendpayingassets)usinganalyticmodelsismoredifficultthanfor
Europeanoptions.
TohandleAmericanoptionpricinginanefficientmannerothermodelshavebeendeveloped.
Threeofthemostwidelyusedmodelswhichareusedwhereappropriateinthethesoftware
availablefromthissiteinclude:
Roll,GeskeandWhaleyanalyticsolution:TheRGWformulacanbeusedforpricing
anAmericancallonastockpayingdiscretedividends.Becauseitisananalyticsolution
itisrelativelyfast.

Black'sapproximationforAmericancalls:AlthoughtheRGWformulaisananalytic
solutionitinvolvessolvingequationsiterativelyandthusitisslowerthanBlack
Scholes.Black'sapproximationbasicallyinvolvesusingtheBlackScholesmodelafter
makingadjustmentstothestockpriceandexpirationdatetotakeaccountofearly
exercise.

BaroneAdesiandWhaleyquadraticapproximation:Ananalyticsolutionfor
Americanputsandcallspayingacontinuousdividend.LiketheRGWformulait
involvessolvingequationsiterativelysowhilstitismuchfasterthanthebinomialmodel
itisstillmuchslowerthanBlackScholes.

TheDelta
AbyproductoftheBlackScholesmodelisthecalculationofthedelta:thedegreetowhichan
optionpricewillmovegivenasmallchangeintheunderlyingstockprice.Forexample,an
optionwithadeltaof0.5willmovehalfacentforeveryfullcentmovementintheunderlying
stock.
Adeeplyoutofthemoneycallwillhaveadeltaveryclosetozeroadeeplyinthemoneycall
willhaveadeltaverycloseto1.
TheformulaforathedeltaofaEuropeancallonanondividendpayingstockis:
Delta=N(d1)(seeBlackScholesformulaaboveford1)
Calldeltasarepositiveputdeltasarenegative,reflectingthefactthattheputoptionpriceand
theunderlyingstockpriceareinverselyrelated.Theputdeltaequalsthecalldelta1.
Thedeltaisoftencalledthehedgeratio:Ifyouhaveaportfolioshortnoptions(egyouhave
writtenncalls)thennmultipliedbythedeltagivesyouthenumberofshares(ieunitsofthe
underlying)youwouldneedtocreatearisklesspositionieaportfoliowhichwouldbeworth
thesamewhetherthestockpricerosebyaverysmallamountorfellbyaverysmall
amount.Insucha"deltaneutral"portfolioanygaininthevalueofthesharesheldduetoa
riseinthesharepricewouldbeexactlyoffsetbyalossonthevalueofthecallswritten,and
viceversa.
Notethatasthedeltachangeswiththestockpriceandtimetoexpirationthenumberofshares
wouldneedtobecontinuallyadjustedtomaintainthehedge.Howquicklythedeltachanges
withthestockpriceisgivenbygamma(see"Greeks"below).
TheOptionsStrategyEvaluationTool,whichcanbedownloadedfromthissite,calculatesand
displaysthedeltaforeachindividualoptiontradeenteredintothetool.Ifyousetupacovered
callintheOptionsStrategyEvaluationToolusingBlackScholesEuropeanpricing(ieselln
callsandbuynunderlyingshares)thenchangethenumberofsharesboughttobeequalto
thenumberofoptionsmultipliedbythedeltayouwillhaveanexampleofahedgedposition.
Noticehowthetimeline(iethecurvedlineshowingtheprofitatthenumberofdaysto
expiration)onthepayoffdiagramjusttouches(butdoesn'tpassthrough)thehorizontalaxisat
onepointonly:thepointequaltothecurrentshareprice.Movingashortdistanceineither
directiononthislinewillhavethesameimpactonprofit.ieyouaredeltahedged.
TheOptionsStrategyEvaluationToolalsocalculatesthepositiondeltaforarangeofstock
pricesanddaystoexpirationthatis,thedeltaoftheentirestrategyconsistingofmultiple
optiontradesandtradesintheunderlyingstock.Thepositiondelta,sometimescalledthe
EquivalentStockPosition(ESP)letsyousee,forexample,howadollarriseintheunderlying
stockpriceswillaffecttheoverallprofitabilityoftheentirestrategy.Forexample,iftheESPofa
portfolio,orstrategy,is2,300itmeansthatthemarketexposureoftheportfolioisequivalent
toaportfolioshort2,300shares.Thusaonedollarriseinthestockpricewillcausethe
profitabilityoftheentirepositiontofallby$2,300.
Theotherposition"Greeks"arealsocalculatedbythemodelaswellseebelow.
Youcanalsoseehowthedeltachangeswithstockprice,volatility,timetoexpirationand
interestratebyusingtheonlineoptionscalculator.

Theother"Greeks"
Inadditiontodeltatherearesomeother"Greeks"whichsomefindusefulwhenconstructing
optionstrategies:
Gamma:Itmeasureshowfastthedeltachangesforsmallchangesintheunderlying
stockprice.iethedeltaofthedelta.
Ifyouarehedgingaportfoliousingthedeltahedgetechniquedescribedunder"Delta",
thenyouwillwanttokeepgammaassmallaspossibleasthesmalleritisthelessoften
youwillhavetoadjustthehedgetomaintainadeltaneutralposition.Ifgammaistoo
largeasmallchangeinstockpricecouldwreckyourhedge.Adjustinggamma,
however,canbetrickyandisgenerallydoneusingoptionsunlikedelta,itcan'tbe
donebybuyingorsellingtheunderlyingassetasthegammaoftheunderlyingassetis,
bydefinition,alwayszerosomoreorlessofitwon'taffectthegammaofthetotal
portfolio.

Vega:Thechangeinoptionpricegivenaonepercentagepointchangeinvolatility.Like
deltaandgamma,vegaisalsousedforhedging.


Theta:Thechangeinoptionpricegivenaonedaydecreaseintimetoexpiration.
Basicallyameasureoftimedecay.Unlessyouandyourportfolioaretravellingatclose
tothespeedoflightthepassageoftimeisconstantandinexorable.Thushedginga
portfolioagainsttimedecay,theeffectsofwhicharecompletelypredictable,wouldbe
pointless.

Rho:Thechangeinoptionpricegivenaonepercentagepointchangeintheriskfree
interestrate.

TheonlineBlackScholescalculatorcalculatesthesederivedmeasuresforeachsetof
variablessubmittedforcalculation.Likedelta,these"Greeks"varywithchangesineachof
theunderlyingBlackScholesvariables.egthegammavariesasthevolatilitychanges.You
canseegraphicallyhoweachderivedmeasurechangesastheunderlyingBlackScholes
variableschange.
TheOptionsStrategyEvaluationToolcalculatestheposition"Greeks"iethe"Greeks"for
individualoptionandstocktradesandfortheentirestrategyorportfolio(ienetposition
"Greeks").Thisletsyouseehowtheprofitabilityofthestrategyisimpactedbychangesto
stockprice,timetoexpiration,volatilityetc.
Allthe"Greeks"canbeviewedgraphicallytherebyhighlightinghowtheychangewithchanges
intheunderlyingassetandwithtime.
TheOptionsStrategyEvaluationToolcontainsanautomaticpositionhedgingfeaturethatlets
youachievetargetneutralityoutcomeswithrespecttodelta,deltaandgamma,vega,delta
andvega,ordelta,gamma,andvega.
FinallytheFinanceAddinforExcelavailablefromthissitecontainsapositionhedging
functionthatnotonlyletsyouachieveneutralityinkeycombinationsofthe"Greeks"butalso
letsyouspecifyspecificpositiveornegativetargetsforindividual"Greeks"andcombinationsof
the"Greeks".

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