Option prices are strongly influenced by changes in volatility. The higher the volatility of the underlying asset, the more likely the option will move into the money and the more valuable it becomes. Conversely, low volatility reduces the chances of the option ending up in the money and lowers its value.
In options trading, the implied volatility is an important parameter used to determine the price of an option. Implied volatility is the market’s expectation of the future volatility of the underlying asset. When the market expects higher volatility in the future, the implied volatility and the price of the option will increase. Conversely, when the market expects lower volatility in the future, the implied volatility and the price of the option will decrease.
It is important to note that option prices are not only affected by the implied volatility of the underlying asset but also by other factors such as the strike price, time to expiration, interest rates, and dividend payouts. Option pricing models such as the Black-Scholes model take into account all these factors to estimate the fair price of an option.
Traders and investors use options pricing and volatility to make informed decisions about their trades. High volatility might suggest a potential big move in the underlying asset, making options more attractive to traders who are willing to take on risk. Low volatility might suggest a stable market, making options less attractive to traders who want to take advantage of price movements.
The National Stock Exchange of India (NSE) uses the Black-Scholes model to calculate the theoretical price of European-style equity options traded on its platform. The Black-Scholes model is a mathematical formula that takes into account several factors, including the underlying asset price, the strike price, time to expiration, risk-free interest rate, and volatility.
Here are the steps involved in calculating option pricing using the Black-Scholes model:
- Determine the current market price of the underlying asset.
- Determine the strike price of the option.
- Determine the time remaining until expiration of the option.
- Determine the risk-free interest rate.
- Determine the implied volatility of the underlying asset. The implied volatility is derived from the market price of the option and is an estimate of the future volatility of the underlying asset.
- Plug these values into the Black-Scholes formula to calculate the theoretical price of the option.
The Black-Scholes model is a widely used options pricing model, but it has some limitations, such as assuming that the underlying asset follows a log-normal distribution and that there are no transaction costs or taxes. NSE and other exchanges use other models or adjustments to the Black-Scholes model to calculate prices for more complex options, such as American-style options or options on futures contracts.
In summary, option price volatility is a critical factor in options pricing, and it’s essential to keep track of the implied volatility of the underlying asset when trading options