Description

Description: This course deepens your understanding of the fundamentals of corporate finance from the perspective of the business manager. Once the course is completed, you will have learned options valuation and pricing and trading analysis.

This course features dynamic and engaging video with audio narration, infographics and short quizzes to test your knowledge.

Background: Regardless of the reasons for trading options or the strategy employed, it is important to understand the factors that determine the value of an option.

The Black-Scholes Model
Is probably the most widely used and best-known theoretical option-valuation model. A theoretical model is a forward-looking model that attempts to determine what the option should sell for in the market given the option terms and the underlying stock’s salient points.

According to the Options Industry Council, a trade group, three factors generally affect the price of an option under Black-Scholes model:
• The option's intrinsic value.
• The likelihood of a significant change in the stock.
• The cost of money, or interest rates.

Intrinsic Value
The Black-Scholes pricing model considers the current price of a stock and the target price as two critical variables in putting a price on an option.

Likelihood of Significant Change: Time Until the Option Expires

Under the Black-Scholes model, an option with a longer life span is more valuable than an otherwise identical option that expires sooner.

Employee stock options often expire many years down the road, sometimes a decade later.

Using the example mentioned earlier, the option with the $100 exercise price would have greater value, all other variables remaining constant, if the time to expiration was 180 days rather than 30 days. This would allow for a longer period for the price of the underlying stock to increase to a value greater than the $100 exercise price. This relationship is shown in this figure:

Likelihood of Significant Change: Volatility
With the Black-Scholes model, volatility is golden. Consider two companies, Boring Story Inc. and Wild Child Corp., which both happen to trade for $25 a share. Now, consider a $30 call option on these stocks. For these options to become "in the money," the stocks would need to increase by $5 before the option expires. From an investor's perspective, the option on Wild Child - which swings wildly in the market - would naturally be more valuable than the option on Boring Story, which historically has changed very little day to day.