Tuesday, March 25, 2008

Options Trading (Basics 2)

In continuation with the earlier article written on March 19, 2008...........
Call option and Put option are also known as option to buy and option to sell respectivelly from a buyers perspective at a certain predesignated price called the 'Strike Price'.
Now let's intutively try to understand what factors would influence the price of the options. So basically how much is the just price that A should charge B. Well ofcourse market forces can determine the price and ultimately that is what govern options prices in reality (no fourmlas!!!) but in this case our market is limited to just two people so the market forces may not work prudently. So let's think about the variables governing the option price.
- The first factor that straightaway comes to mind is the goal difference on which the option is bought. For eg. if the B buys from A a call option on the victory of Italy by two goals or more the option value would be lesser when compared to the scenario wherein B buys from A a call option on the victory of Italy by any number of goals as chances of the first scenario happening is lesser than the second.
-The second factor is time. Let's consider two scenarios wherein in the first scenario the bet is made at the start of the match and in the other scenario the bet is made in the injury time of the second half (both teams stuck at 0-0). Obviously the chances of B winning the bet is far less in scenario B as compared to scenario A and hence the value of option is greater for first scenario vis as vis second.
So to sum it up this option can be valued on the basis of goal difference (distance from the current price in generic form) and time before expiry. These two are predictable components. What makes the option trading fun is the third and most critical component 'chance' or in mathematical form probability. Though the underlying distribution of this probablity is unknown (don't assume normal and ruin the real fun of options!!!). The probability is governed by the distance, time and to a very limited extent past track record. However let me add that it is this notorious unpredicatable probability component that can make or break fortunes in option trading...............

1 comment:

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