Option style

In finance, the style or family of an option is a general term denoting the class into which the
option falls, usually defined by the dates on which the option may be exercised. The vast
majority of options are either European or American (style) options. These options - as well as
others where the payoff is calculated similarly - are referred to as "vanilla options". Options
where the payoff is calculated differently are categorized as "exotic options". Exotic options
can pose challenging problems in valuation and hedging.

• 1 American and European options

o 1.1 Expiration date
o 1.2 Difference in value
• 2 Non-vanilla exercise rights
• 3 "Exotic" options with standard exercise styles
• 4 Non-vanilla path dependent "exotic" options
• 5 Related
• 6 See also
• 7 Options
• 8 References
• 9 External links

o 9.1 Simulators and Option Calculators

American and European options

The key difference between American and European options relates to when the options can be
exercised:

• A European option may be exercised only at the expiry date of the option, i.e. at a
single pre-defined point in time.
• An American option on the other hand may be exercised at any time before the expiry
date.

For both, the pay-off - when it occurs - is via:

Max [ (S – K), 0 ], for a call option

Max [ (K – S), 0 ], for a put option:

(Where K is the Strike price and S is the spot price of the underlying asset)

Option contracts traded on futures exchanges are mainly American-style, whereas those traded
over-the-counter are mainly European.
Nearly all stock and equity options are American options, while indexes are generally
represented by European options. A list of European and American options can be found on the
Options Industry Council website.

[edit] Expiration date

American options expire the third Saturday of every month. They are closed for trading the
Friday prior.

European options expire the Friday prior to the third Saturday of every month. Therefore they are
closed for trading the Thursday prior to the third Saturday of every month.

[edit] Difference in value

European options are typically valued using the Black-Scholes or Black model formula. This is a
simple equation with a closed-form solution that has become standard in the financial
community. There are no general formulae for American options, but a choice of models to
approximate the price are available (for example Whaley, binomial options model, and others -
there is no consensus on which is preferable)[1].

An investor holding an American-style option and seeking optimal value will only exercise it
before maturity under certain circumstances. Any option has a non-negative time value and is
usually worth more unexercised. Owners who wish to realise the full value of their option will
mostly prefer to sell it on, rather than exercise it immediately, sacrificing the time value.[2]

Where an American and a European option are otherwise identical (having the same strike price,
etc.), the American option will be worth at least as much as the European (which it entails). If it
is worth more, then the difference is a guide to the likelihood of early exercise. In practice, one
can calculate the Black-Scholes price of a European option that is equivalent to the American
option (except for the exercise dates of course). The difference between the two prices can then
be used to calibrate the more complex American option model.

To account for the American's higher value there must be some situations in which it is optimal
to exercise the American option before the expiration date. This can arise in several ways, such
as:

• An in the money (ITM) call option on a stock is often exercised just before the stock pays
a dividend which would lower its value by more than the option's remaining time value

• A deep ITM currency option (FX option) where the strike currency has a lower interest
rate than the currency to be received will often be exercised early because the time value
sacrificed is less valuable than the expected depreciation of the received currency against
the strike.

• An American bond option on the dirty price of a bond (such as some convertible bonds)
may be exercised immediately if ITM and a coupon is due.
 • A put option on gold will be exercised early when deep ITM, because gold tends to hold
its value whereas the currency used as the strike is often expected to lose value through
inflation if the holder waits until final maturity to exercise the option (they will almost
certainly exercise a contract deep ITM, minimizing its time value).

[edit] Non-vanilla exercise rights

There are other, more unusual exercise styles in which the pay-off value remains the same as a
standard option (as in the classic American and European options above) but where early
exercise occurs differently:

• A Bermudan option is an option where the buyer has the right to exercise at a set
(always discretely spaced) number of times. This is intermediate between a European
option—which allows exercise at a single time, namely expiry—and an American option,
which allows exercise at any time (the name is a pun: Bermuda is between America and
Europe). For example a typical Bermudan swaption might confer the opportunity to enter
into an interest rate swap. The option holder might decide to enter into the swap at the
first exercise date (and so enter into, say, a ten-year swap) or defer and have the
opportunity to enter in six months time (and so enter a nine-year and six-month swap).
Most exotic interest rate options are of Bermudan style.

• A Canary option is an option whose exercise style lies somewhere between European
options and Bermudan options. (The name refers to the relative geography of the Canary
Islands.) Typically, the holder can exercise the option at quarterly dates, but not before a
set time period (typically one year) has elapsed. The term was coined by Keith Kline,
who at the time was an agency fixed income trader at the Bank of New York.

• A capped-style option is not an interest rate cap but a conventional option with a pre-
defined profit cap written into the contract. A capped-style option is automatically
exercised when the underlying security closes at a price making the option's mark to
market match the specified amount.

• A compound option is an option on another option, and as such presents the holder with
two separate exercise dates and decisions. If the first exercise date arrives and the 'inner'
option's market price is below the agreed strike the first option will be exercised
(European style), giving the holder a further option at final maturity.

• A shout option allows the holder effectively two exercise dates: during the life of the
option they can (at any time) "shout" to the seller that they are locking-in the current
price, and if this gives them a better deal than the pay-off at maturity they'll use the
underlying price on the shout date rather than the price at maturity to calculate their final
pay-off.

• A swing option gives the purchaser the right to exercise one and only one call or put on
any one of a number of specified exercise dates (this latter aspect is Bermudan). Penalties
are imposed on the buyer if the net volume purchased exceeds or falls below specified
 upper and lower limits. Allows the buyer to "swing" the price of the underlying asset.
Primarily used in energy trading.

[edit] "Exotic" options with standard exercise styles

These options can be exercised either European style or American style; they differ from the
plain vanilla option only in the calculation of their pay-off value:

• A cross option (or composite option) is an option on some underlying in one currency
with a strike denominated in another currency. For example a standard call option on
IBM, which is denominated in dollars pays $MAX(S-K,0) (where S is the stock price at
maturity and K is the strike). A composite stock option might pay JPYMAX(S/Q-K,0),
where Q is the prevailing FX rate. The pricing of such options naturally needs to take into
account FX volatility and the correlation between the exchange rate of the two currencies
involved and the underlying stock price.

• A quanto option is a cross option in which the exchange rate is fixed at the outset of the
trade, typically at 1. The payoff of an IBM quanto call option would then be JPYmax(S-
K,0).

• An exchange option is the right to exchange one asset for another (such as a sugar future
for a corporate bond).

• A basket option is an option on the weighted average of several underlyings

• A rainbow option is a basket option where the weightings depend on the final
performances of the components. A common special case is an option on the worst-
performing of several stocks.

• A Low Exercise Price Option (LEPO) is a European style call option with a low
exercise price of $0.01.

[edit] Non-vanilla path dependent "exotic" options

The following "exotic options" are still options, but have payoffs calculated quite differently
from those above. Although these instruments are far more unusual they can also vary in exercise
style (at least theoretically) between European and American:

• A lookback option is a path dependent option where the option owner has the right to
buy (sell) the underlying instrument at its lowest (highest) price over some preceding
period.

• An Asian option (or Average option) is an option where the payoff is not determined by
the underlying price at maturity but by the average underlying price over some pre-set
period of time. For example an Asian call option might pay
MAX(DAILY_AVERAGE_OVER_LAST_THREE_MONTHS(S) - K, 0).[3] Asian
 options were originated in Asian markets to prevent option traders from attempting to
manipulate the price of the underlying security on the exercise date.[citation needed]

• A Russian option is a lookback option which runs for perpetuity. That is, there is no end
to the period into which the owner can look back.

• A game option or Israeli option is an option where the writer has the opportunity to
cancel the option he has offered, but must pay the payoff at that point plus a penalty fee.

• The payoff of a Cumulative Parisian option is dependent on the total amount of time
the underlying asset value has spent above or below a strike price.

• The payoff of a Standard Parisian option is dependent on the maximum amount of time
the underlying asset value has spent consecutively above or below a strike price.

• A barrier option involves a mechanism where if a 'limit price' is crossed by the

underlying, the option either can be exercised or can no longer be exercised.

• A double barrier option involves a mechanism where if either of two 'limit prices' is
crossed by the underlying, the option either can be exercised or can no longer be
exercised.

• A Cumulative Parisian barrier option involves a mechanism where if the total amount
of time the underlying asset value has spent above or below a 'limit price', the option can
be exercised or can no longer be exercised.

• A Standard Parisian barrier option involves a mechanism where if the maximum

amount of time the underlying asset value has spent consecutively above or below a 'limit
price', the option can be exercised or can no longer be exercised.

• A reoption occurs when a contract has expired without having been exercised. The
owner of the underlying security may then reoption the security.

• A binary option (also known as a digital option) pays a fixed amount, or nothing at all,
depending on the price of the underlying instrument at maturity.

• A chooser option gives the purchaser a fixed period of time to decide whether the
derivative will be a vanilla call or put.

• A forward start option is an option whose strike price is determined in the future

• A cliquet option is a sequence of forward start options

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 Option Pricing Models and the "Greeks"

Up Pricing Models Used

Black-Scholes The Black-Scholes model and the Cox, Ross and Rubinstein binomial
model are the primary pricing models used by the software available from
Binomial Model this site (Finance Add-in for Excel, the Options Strategy Evaluation Tool,
and the on-line pricing calculators.)
Other Models
Both models are based on the same theoretical foundations and assumptions
(such as the geometric Brownian motion theory of stock price behaviour
The Delta and risk-neutral valuation). However, there are also some some important
differences between the two models and these are highlighted below.
Other "Greeks"

The Black-Scholes Model

The Black-Scholes model is used to calculate a theoretical call price

(ignoring dividends paid during the life of the option) using the five key
determinants of an option's price: stock price, strike price, volatility, time to
expiration, and short-term (risk free) interest rate.

The original formula for calculating the theoretical option price (OP) is as
follows:

Where:

The variables are:

S = stock price
 X = strike price
t = time remaining until expiration, expressed as a percent of a year
r = current continuously compounded risk-free interest rate
v = annual volatility of stock price (the standard deviation of the short-term
returns over one year). See below for how to estimate volatility.
ln = natural logarithm
N(x) = standard normal cumulative distribution function
e = the exponential function

Lognormal distribution -- but how realistic?

The model is based on a normal distribution of underlying asset returns

which is the same thing as saying that the underlying asset prices
themselves are lognormally distributed. A lognormal distribution has a
longer right tail compared with a normal, or bell-shaped, distribution. The
lognormal distribution allows for a stock price distribution of between zero
and infinity (ie no negative prices) and has an upward bias (representing the
fact that a stock price can only drop 100% but can rise by more than
100%).

In practice underlying asset price distributions often depart significantly

from the lognormal. For example historical distributions of underlying asset
returns often have fatter left and right tails than a normal distribution
indicating that dramatic market moves occur with greater frequency than
would be predicted by a normal distribution of returns-- ie more very high
returns and more very low returns.

A corollary of this is the volatility smile -- the way in which at-the-money

options often have a lower volatility than deeply out-of- the-money options
or deeply in-the- money options.

The Excel add-in which can be downloaded from this site contains three sets
of tools for dealing with non-lognormally distributed asset prices and the
volatility smile:

Modified Black-Scholes and binomial pricing (using implied binomial

trees) for European and American option pricing with non-lognormal
distributions. These models can be used to see the impact on option
prices of non-lognormal price distributions (as measured by coefficents
of skewness (symmetry) and kurtosis (fatness of distribution tails and
height of peaks)), and to calculate and plot the volatility smile implied
by these distributions.
 Measuring the degree to which historical asset price distributions
diverge from the lognormal (as measured by coefficents of skewness
and kurtosis).

Plotting non-lognormal distribution curves for specified coefficients of

skewness and Kurtosis (as well as volatility etc) to see how they differ
from the lognormal.

In addition to using the add-in you can use the on-line stock price
distribution calculator to examine the sensitivity of the shape of the
lognormal stock price distribution curve to changes in time, volatility, and
expected growth rates. And you can also use the on-line stock price
probability calculator to look at the probabilities of stock prices exceeding
upper and lower boundary prices -- both at the end of a specified number of
days and at any time during the period.

Volatility -- implied or historical?

This is the most critical parameter for option pricing -- option prices are
very sensitive to changes in volatility. Volatility however cannot be directly
observed and must be estimated.

Whilst implied volatility -- the volatility of the option implied by current

market prices -- is commonly used the argument that this is the "best"
estimate is somewhat circular. Skilled options traders will not rely solely on
implied volatility but will look behind the estimates to see whether or not
they are higher or lower than you would expect from historical and current
volatilities, and hence whether options are more expensive or cheaper than
perhaps they should be.

It's a slight over simplification, but basically implied volatility will give you
the price of an option; historical volatility will give you an indication of its
value. It's important to understand both. For instance, if your forecast of
volatility based on historical prices is greater than current implied volatility
(options under valued) you might want to buy a straddle; if your historical
forecast is less than implied volatility you might want to sell a straddle.

This site contains one of the most comprehensive sets of tools available for
getting a handle on volatility. The tools include an Historic Volatility
 Calculator (which automatically extracts historic prices from the web, and
calculates and graphs volatility), an Implied Volatility Calculator (which
retrieves and calculates implied volatility for an entire option chain), and an
Excel Add-in (for those who like to build their own Excel applications). The
volatility functions in the add-in include:

Implied volatility calculation (American and European options, with

and without dividends).

Equally weighted historical volatility estimation using historical

prices: one or more of high-low, closing, and open prices. All the price
data required are available at no charge at sites such as Yahoo.

Exponentially weighted historical volatility estimation using the

EWMA (exponentially weighted moving average) model or the
GARCH model. These models give greater emphasis to more recent
prices.

Volatility forecasting using the GARCH model, which lets you see
how volatility is likely to move in the future. A common application of
this is to create volatility term structures for the weeks or months ahead
to answer questions like "what volatility should I use for pricing an
option with a life of three months?".

The implied volatility, historical volatility, and forecast volatility tools are
complementary. With volatility being such a critical factor a good options
trader will use all three sets of tools to help form a view about the volatility
to use in pricing options.

See the Finance Add-in for Excel and Volatility FAQs pages, Historic
Volatility Calculator page, Implied Volatility Calculator page, and the on-
line demos for more information.

Risk-neutral valuation -- does the expected stock return matter?

Unlike volatility, which is all important for determining the fair value of an
option, views about the future direction of an underlying asset (ie whether
you think it will go up or down in the future and by how much) are
 completely irrelevant.

Significantly, the expected rate of return of the stock (which would

incorporate risk preferences of investors as an equity risk premium) is not
one of the variables in the Black-Scholes model (or any other model for
option valuation). The important implication is that the value of an option is
completely independent of the expected growth of the underlying asset (and
is therefore risk neutral).

Thus, while any two investors may strongly disagree on the rate of return
they expect on a stock they will, given agreement to the assumptions of
volatility and the risk free rate, always agree on the fair value of the option
on that underlying asset.

The fact that a prediction of the future price of the underlying asset is not
necessary to value an option may appear to be counter intuitive, but it can
easily be shown to be correct. Dynamically hedging a call using underlying
asset prices generated from Monte Carlo simulation is a particularly
convincing way of demonstrating this. Irrespective of the assumptions
regarding stock price growth built into the Monte Carlo simulation the cost
of hedging a call (ie dynamically maintaining a delta neutral position by
buying & selling the underlying asset) will always be the same, and will be
very close to the Black-Scholes value. (The Excel add-in available from this
site contains a Monte Carlo simulation component which can be used for
this purpose.)

Putting it another way, whether the stock price rises or falls after, eg,
writing a call, it will always cost the same (providing volatility remains
constant) to dynamically hedge the call and this cost, when discounted back
to present value at the risk free rate, is very close to the Black-Scholes
value.

Which is hardly surprising given that the Black-Scholes price is nothing

more than the amount an option writer would require as compensation for
writing a call and completely hedging the risk. The important point is that
the hedger's view about future stock prices is irrelevant.

This key concept underlying the valuation of all derivatives -- that fact that
the price of an option is independent of the risk preferences of investors -- is
called risk-neutral valuation. It means that all derivatives can be valued by
assuming that the return from their underlying assets is the risk free rate.

Advantages & Limitations

Advantage: The main advantage of the Black-Scholes model is speed -- it
lets you calculate a very large number of option prices in a very short time.

Limitation: The Black-Scholes model has one major limitation: it cannot

be used to accurately price options with an American-style exercise as it
only calculates the option price at one point in time -- at expiration. It does
not consider the steps along the way where there could be the possibility of
early exercise of an American option.

As all exchange traded equity options have American-style exercise (ie they
can be exercised at any time as opposed to European options which can only
be exercised at expiration) this is a significant limitation.

The exception to this is an American call on a non-dividend paying asset. In

this case the call is always worth the same as its European equivalent as
there is never any advantage in exercising early.

Various adjustments are sometimes made to the Black-Scholes price to

enable it to approximate American option prices (eg the Fischer Black
Pseudo-American method) but these only work well within certain limits
and they don't really work well for puts.

The Binomial Model

The binomial model breaks down the time to expiration into potentially a
very large number of time intervals, or steps. A tree of stock prices is
initially produced working forward from the present to expiration. At each
step it is assumed that the stock price will move up or down by an amount
calculated using volatility and time to expiration. This produces a binomial
distribution, or recombining tree, of underlying stock prices. The tree
represents all the possible paths that the stock price could take during the
life of the option.

At the end of the tree -- ie at expiration of the option -- all the terminal
option prices for each of the final possible stock prices are known as they
simply equal their intrinsic values.

Next the option prices at each step of the tree are calculated working back
from expiration to the present. The option prices at each step are used to
derive the option prices at the next step of the tree using risk neutral
valuation based on the probabilities of the stock prices moving up or down,
the risk free rate and the time interval of each step. Any adjustments to
stock prices (at an ex-dividend date) or option prices (as a result of early
 exercise of American options) are worked into the calculations at the
required point in time. At the top of the tree you are left with one option
price.

To get a feel for how the binomial model works you can use the on-line
binomial tree calculators: either using the original Cox, Ross, & Rubinstein
tree or the equal probabilities tree, which produces equally accurate results
while overcoming some of the limitations of the C-R-R model. The
calculators let you calculate European or American option prices and
display graphically the tree structure used in the calculation. Dividends can
be specified as being discrete or as an annual yield, and points at which
early exercise is assumed for American options are highlighted.

Advantages & Limitations

Advantage: The big advantage the binomial model has over the Black-
Scholes model is that it can be used to accurately price American options.
This is because with the binomial model it's possible to check at every point
in an option's life (ie at every step of the binomial tree) for the possibility of
early exercise (eg where, due to eg a dividend, or a put being deeply in the
money the option price at that point is less than its intrinsic value).

Where an early exercise point is found it is assumed that the option holder
would elect to exercise, and the option price can be adjusted to equal the
intrinsic value at that point. This then flows into the calculations higher up
the tree and so on.

The on-line binomial tree graphical option calculator highlights those points
in the tree structure where early exercise would have have caused an
American price to differ from a European price.

The binomial model basically solves the same equation, using a

computational procedure that the Black-Scholes model solves using an
analytic approach and in doing so provides opportunities along the way to
check for early exercise for American options.

Limitation: The main limitation of the binomial model is its relatively

slow speed. It's great for half a dozen calculations at a time but even with
today's fastest PCs it's not a practical solution for the calculation of
thousands of prices in a few seconds.

Relationship to the Black-Scholes model

The same underlying assumptions regarding stock prices underpin both the
binomial and Black-Scholes models: that stock prices follow a stochastic
process described by geometric brownian motion. As a result, for European
options, the binomial model converges on the Black-Scholes formula as the
number of binomial calculation steps increases. In fact the Black-Scholes
model for European options is really a special case of the binomial model
where the number of binomial steps is infinite. In other words, the binomial
model provides discrete approximations to the continuous process
underlying the Black-Scholes model.

Whilst the Cox, Ross & Rubinstein binomial model and the Black-Scholes
model ultimately converge as the number of time steps gets infinitely large
and the length of each step gets infinitesimally small this convergence,
except for at-the-money options, is anything but smooth or uniform. To
examine the way in which the two models converge see the on-line Black-
Scholes/Binomial convergence analysis calculator. This lets you examine
graphically how convergence changes as the number of steps in the
binomial calculation increases as well as the impact on convergence of
changes to the strike price, stock price, time to expiration, volatility and risk
free interest rate.

Other Models used by the Software for American Options

For rapid calculation of a large number of prices, analytic models, like

Black-Scholes, are the only practical option on even the fastest PCs.
However, the pricing of American options (other than calls on non-dividend
paying assets) using analytic models is more difficult than for European
options.

To handle American option pricing in an efficient manner other models

have been developed. Three of the most widely used models which are used
where appropriate in the the software available from this site include:

Roll, Geske and Whaley analytic solution: The RGW formula can be
used for pricing an American call on a stock paying discrete dividends.
Because it is an analytic solution it is relatively fast.

Black's approximation for American calls: Although the RGW

formula is an analytic solution it involves solving equations iteratively
 and thus it is slower than Black-Scholes. Black's approximation
basically involves using the Black-Scholes model after making
adjustments to the stock price and expiration date to take account of
early exercise.

Barone-Adesi and Whaley quadratic approximation: An analytic

solution for American puts and calls paying a continuous dividend.
Like the RGW formula it involves solving equations iteratively so
whilst it is much faster than the binomial model it is still much slower
than Black-Scholes.

The Delta

A by-product of the Black-Scholes model is the calculation of the delta: the

degree to which an option price will move given a small change in the
underlying stock price. For example, an option with a delta of 0.5 will
move half a cent for every full cent movement in the underlying stock.

A deeply out-of-the-money call will have a delta very close to zero; a

deeply in-the-money call will have a delta very close to 1.

The formula for a the delta of a European call on a non-dividend paying

stock is:

Delta = N(d1) (see Black-Scholes formula above for d1)

Call deltas are positive; put deltas are negative, reflecting the fact that the
put option price and the underlying stock price are inversely related. The
put delta equals the call delta - 1.

The delta is often called the hedge ratio: If you have a portfolio short n
options (eg you have written n calls) then n multiplied by the delta gives
you the number of shares (ie units of the underlying) you would need to
create a riskless position - ie a portfolio which would be worth the same
whether the stock price rose by a very small amount or fell by a very small
amount. In such a "delta neutral" portfolio any gain in the value of the
shares held due to a rise in the share price would be exactly offset by a loss
on the value of the calls written, and vice versa.

Note that as the delta changes with the stock price and time to expiration the
number of shares would need to be continually adjusted to maintain the
 hedge. How quickly the delta changes with the stock price is given by
gamma (see "Greeks" below).

The Options Strategy Evaluation Tool, which can be downloaded from this
site, calculates and displays the delta for each individual option trade
entered into the tool. If you set up a covered call in the Options Strategy
Evaluation Tool using Black-Scholes European pricing (ie sell n calls and
buy n underlying shares) then change the number of shares bought to be
equal to the number of options multiplied by the delta you will have an
example of a hedged position. Notice how the time line (ie the curved line
showing the profit at the number of days to expiration) on the payoff
diagram just touches (but doesn't pass through) the horizontal axis at one
point only: the point equal to the current share price. Moving a short
distance in either direction on this line will have the same impact on profit.
ie you are delta hedged.

The Options Strategy Evaluation Tool also calculates the position delta for a
range of stock prices and days to expiration -- that is, the delta of the entire
strategy consisting of multiple option trades and trades in the underlying
stock. The position delta, sometimes called the Equivalent Stock Position
(ESP) lets you see, for example, how a dollar rise in the underlying stock
prices will affect the overall profitability of the entire strategy. For example,
if the ESP of a portfolio, or strategy, is -2,300 it means that the market
exposure of the portfolio is equivalent to a portfolio short 2,300 shares.
Thus a one dollar rise in the stock price will cause the profitability of the
entire position to fall by $2,300.

The other position "Greeks" are also calculated by the model as well -- see
below.

You can also see how the delta changes with stock price, volatility, time to
expiration and interest rate by using the on-line options calculator.

The other "Greeks"

In addition to delta there are some other "Greeks" which some find useful
when constructing option strategies:

Gamma: It measures how fast the delta changes for small changes in
the underlying stock price. ie the delta of the delta.

If you are hedging a portfolio using the delta-hedge technique

 described under "Delta", then you will want to keep gamma as small as
possible as the smaller it is the less often you will have to adjust the
hedge to maintain a delta neutral position. If gamma is too large a
small change in stock price could wreck your hedge. Adjusting
gamma, however, can be tricky and is generally done using options --
unlike delta, it can't be done by buying or selling the underlying asset
as the gamma of the underlying asset is, by definition, always zero so
more or less of it won't affect the gamma of the total portfolio.

Vega: The change in option price given a one percentage point change
in volatility. Like delta and gamma, vega is also used for hedging.

Theta: The change in option price given a one day decrease in time to
expiration. Basically a measure of time decay. Unless you and your
portfolio are travelling at close to the speed of light the passage of time
is constant and inexorable. Thus hedging a portfolio against time
decay, the effects of which are completely predictable, would be
pointless.

Rho: The change in option price given a one percentage point change
in the risk-free interest rate.

The on-line Black-Scholes calculator calculates these derived measures for

each set of variables submitted for calculation. Like delta, these "Greeks"
vary with changes in each of the underlying Black-Scholes variables. eg the
gamma varies as the volatility changes. You can see graphically how each
derived measure changes as the underlying Black-Scholes variables change.

The Options Strategy Evaluation Tool calculates the position "Greeks" -- ie

the "Greeks" for individual option and stock trades and for the entire
strategy or portfolio (ie net position "Greeks"). This lets you see how the
profitability of the strategy is impacted by changes to stock price, time to
expiration, volatility etc.

All the "Greeks" can be viewed graphically thereby highlighting how they
change with changes in the underlying asset and with time.

The Options Strategy Evaluation Tool contains an automatic position

hedging feature that lets you achieve target neutrality outcomes with respect
 to delta, delta and gamma, vega, delta and vega, or delta, gamma, and
vega.

Finally the Excel add-in available from this site contains a position hedging
function that not only lets you achieve neutrality in key combinations of the
"Greeks" but also lets you specify specific positive or negative targets for
individual "Greeks" and combinations of the "Greeks".

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Stochastic volatility

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See also Volatility (finance).

Stochastic volatility models are used in the field of Mathematical finance to evaluate derivative
securities, such as options. The name derives from the models' treatment of the underlying
security's volatility as a random process, governed by state variables such as the price level of the
underlying security, the tendency of volatility to revert to some long-run mean value, and the
variance of the volatility process itself, among others.

Stochastic volatility models are one approach to resolve a shortcoming of the Black-Scholes
model. In particular, these models assume that the underlying volatility is constant over the life
of the derivative, and unaffected by the changes in the price level of the underlying security.
However, these models cannot explain long-observed features of the implied volatility surface
such as volatility smile and skew, which indicate that implied volatility does tend to vary with
respect to strike price and expiry. By assuming that the volatility of the underlying price is a
stochastic process rather than a constant, it becomes possible to model derivatives more
accurately.

Monte Carlo methods for option pricing

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It has been suggested that this article or section be merged into Monte Carlo methods
in finance. (Discuss)

In mathematical finance, a Monte Carlo option model uses Monte Carlo methods to calculate
the value of an option with multiple sources of uncertainty or with complicated features. [1]
The term 'Monte Carlo method' was coined by Stanislaw Ulam in the 1940s. The first application
to option pricing was by Phelim Boyle in 1977 (for European options). In 1996, M. Broadie and
P. Glasserman showed how to price Asian options by Monte Carlo. In 2001 F. A. Longstaff and
E. S. Schwartz developed a practical Monte Carlo method for pricing American-style options.

Contents

[hide]

• 1 Methodology
• 2 Application
• 3 References
o 3.1 Notes
o 3.2 Articles
• 4 Resources
o 4.1 Books
o 4.2 Software

• 5 External links

[edit] Methodology

In terms of theory, Monte Carlo valuation relies on risk neutral valuation.[1] Here the price of the
option is its discounted expected value; see risk neutrality and Rational pricing: Risk Neutral
Valuation. The technique applied then, is (1) to generate several thousand possible (but random)
price paths for the underlying (or underlyings) via simulation, and (2) to then calculate the
associated exercise value (i.e. "payoff") of the option for each path. (3) These payoffs are then
averaged and (4) discounted to today. This result is the value of the option.[2]

This approach, although relatively straight-forward, allows for increasing complexity:

• An option on equity may be modelled with one source of uncertainty: the price of the
underlying stock in question. [2] Here the price of the underlying instrument is usually
modelled such that it follows a geometric Brownian motion with constant drift and
volatility . So: , where is found via a random
sampling from a normal distribution; see further under Black-Scholes. (Since the
underlying random process is the same, for enough price paths, the value of a european
option here should be the same as under Black Scholes).

• In other cases, the source of uncertainty may be at a remove. For example, for bond
options [3] the underlying is a bond, but the source of uncertainty is the annualized interest
rate (i.e. the short rate). Here, for each randomly generated yield curve we observe a
different resultant bond price on the option's exercise date; this bond price is then the
input for the determination of the option's payoff. The same approach is used in valuing
swaptions, [4] where the value of the underlying swap is also a function of the evolving
 interest rate. For the models used to simulate the interest-rate see further under Short-rate
model.

• Monte Carlo Methods allow for a compounding in the uncertainty. [5] For example, where
the underlying is denominated in a foreign currency, an additional source of uncertainty
will be the exchange rate: the underlying price and the exchange rate must be separately
simulated and then combined to determine the value of the underlying in the local
currency. In all such models, correlation between the underlying sources of risk is also
incorporated; see Cholesky decomposition: Monte Carlo simulation. Further
complications, such as the impact of commodity prices or inflation on the underlying, can
also be introduced. Since simulation can accommodate complex problems of this sort, it
is often used in analysing real options [1] where management's decision at any point is a
function of multiple underlying variables.

• Simulation can be used to value options where the payoff depends on the value of
multiple underlying assets [6] such as a Basket option or Rainbow option. Here,
correlation between assets is similarly incorporated.

• As required, the stochastic process of the underlying(s) may be specified so as to exhibit

jumps or mean reversion or both.[7] Further, some models even allow for (randomly)
varying statistical (and other) parameters of the sources of uncertainty. For example, in
models incorporating stochastic volatility, the volatility of the underlying changes with
time; see Heston model.

[edit] Application

As can be seen, Monte Carlo Methods are particularly useful in the valuation of options with
multiple sources of uncertainty or with complicated features which would make them difficult to
value through a straightforward Black-Scholes style computation. The technique is thus widely
used in valuing Asian options [8] and in real options analysis. [1][5]

Conversely, however, if an analytical technique for valuing the option exists - or even a numeric
technique, such as a (modified) pricing tree [8] - Monte Carlo methods will usually be too slow to
be competitive. They are, in a sense, a method of last resort; [8] see further under Monte Carlo
methods in finance. With faster computing capability this computational constraint is less of a
concern.

Finite difference methods for option pricing

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Finite difference methods for option pricing are numerical methods used in mathematical
finance for the valuation of options.[1] Finite difference methods were first applied to option
pricing by Eduardo Schwartz in 1977.[2]
Finite difference methods can solve derivative pricing problems that have, in general, the same
level of complexity as those problems solved by tree approaches,[1] and are therefore usually
employed only when other approaches are inappropriate. At the same time, like tree-based
methods, this approach is limited in terms of the number of underlying variables, and for
problems with multiple dimensions, Monte Carlo methods for option pricing are usually
preferred.

The approach is due to the fact that the evolution of the option value can be modelled via a
partial differential equation (PDE), as a function of (at least) time and price of underlying; see
for example Black–Scholes PDE. Once in this form, a finite difference model can be derived,
and the valuation obtained.[2] Here, essentially, the PDE is expressed in a discretized form, using
finite differences, and the evolution in the option price is then modelled using a lattice with
corresponding dimensions; here, time runs from 0 to maturity and price runs from 0 to a "high"
value, such that the option is deeply in or out of the money.

The option is valued as follows:[3]

• Maturity values are simply the difference between the exercise price of the option and the
value of the underlying at each point.

• Values at the boundary prices are set based on moneyness or arbitrage bounds on option
prices.

• Values at other lattice points are calculated recursively, starting at the time step preceding
maturity and ending at time = 0. Here, using a technique such as Crank–Nicolson or the
explicit method:

1. the PDE is discretized per the technique chosen, such that the value at each lattice point is
specified as a function of the value at later and adjacent points; see Stencil (numerical
analysis);
2. the value at each point is then found using the technique in question.

• The value of the option today, where the underlying is at its spot price, (or at any
time/price combination,) is then found by interpolation.

As above, these methods and tree-based methods are able to handle problems which are
equivalent in complexity. In fact, when standard assumptions are applied it can be shown that the
explicit technique encompasses the binomial and trinomial tree methods.[4] Tree based methods,
then, suitably parameterized, are a special case of the explicit finite difference method.[5]

The advantages and disadvantages of options

Options are a very unique investment vehicle so it is important to learn the unique characteristics
of options before you decide to trade them.

Advantages
 • Leverge. Options allow you to employ considerable leverage. This is an advantage to
dsciplined traders who know how to use leverage.

• Risk/reward ratio. Some strategies, like buying options, allows you to have unlimited
upside with limited downside.

• Unique Strategies. Options allow you to create unique strategies to take advantage of
different charactersitcs of the market - like volatility and time decay.

• Low capital requirements. Options alow you to take a position with very low capital
requirements. Someone can do a lot in the options market with $1,000 but not so much
with $1,000 in the stock market.

Disadvantages

• Lower liquidity. Many individual stock options don't have much volume at all. The fact
that eacg optionable stock will have options trading at different strike prices and
expirations means that the particular option you are teading will be very low volume
unless it is one of the most popular stocks or stock indexes. This lower liquidity won't
matter much to a small trader that is trading just 10 contracts though.

• Higher spreads. Options tend to have higher spreads because of the lack of liquidity.
This means it will cost you more in indirect costs when doing an option trade because
you will be giving up the spread when you trade.

• Higher commissions. Options trades will cost you more in commission per dollar
invested. These commissions may be even higher for spreads where you have to pay
commissions for both sides of the spread.

• Complicated. Options are very complicated to beginners. Most beginners, and even
some advanced investors, think they understand them when they don't.

• Time Decay. When buying options you lose the time value of the options as you hold
them. There are no exceptions to this rule.

• Less information. Options can be a pain when it is harder to get quotes or other standard
analystical information like the implied volatility.

• Options not available for all stocks. Although options are available on a good number
of stocks, this still limits the number of possibilities available to you.