5

We are currently learning about the Black-Scholes Merton Model. I understand the process of finding the call option. However, I'm wondering what the answer actually means.

For example:

Stock Price = 95 Exercise Price = 100 Maturity = 2 months Risk-free rate = 4.8% Volatility = 26%

Using the data, the call option is $2.34 (I used an online calculator in this case), but what exactly does that mean? Does that mean the buyer has the obligation to buy the stock for $2.34?

  • The value is always zero. You never get anything back after it goes over the event horizon, it all just gets spaghettified. Oh wait... never mind. – CactusCake Apr 19 '18 at 14:06
7

Using the data, the call option is $2.34, but what exactly does that mean? Does that mean the buyer has the obligation to buy the stock for $2.34?

No, a call option is when someone purchases the right to buy the stock at the exercise price. The obligation is on the seller to provide the stock. The buyer can just let the option go unexercised if the buyer does not want the stock at the exercise price. Many options are never exercised. This may mean that the buyer of the option no longer wants that stock. Or it may mean that the buyer can get a better price than 100. It only makes sense to use the option if the price is higher than 100.

The $2.34 is the price of the option itself. The buyer pays that immediately. Within the maturity period (two months in this example), the buyer of the option can call it and purchase at the exercise price (100 in this example). I.e. the 100 is the price at which the seller is obligated to sell the stock in this example.

The basic idea is that the buyer of the option wants to buy the stock if it goes up beyond 100. Black/Scholes/Merton determines a reasonable valuation of that option based on various parameters.

  • Is a call option comparable to insurance premiums? – pat3d3r Apr 18 '18 at 9:25
  • (1) You don't " just let the option go unexercised" if you don't "want the stock at the exercise price". There is usually salvage value before expiry. (2) "Many options are never exercised" is not because the buyer "no longer wants that stock". Lack of exercise is usually because the underlying did not finish ITM or because option traders never wanted it in the first place. (3) Yes, buyer wants the stock to go up beyond $100 if only long this call. But it could double in value without doing that. If hedging with the call, no desire at all for price increase. – Bob Baerker Apr 18 '18 at 11:34
  • @pat3d3r Options can be "comparable to insurance premiums". In the conventional sense, long put insures the value of an asset.You pay a premium and deductible is the distance down to the strike price (if any). In your personal life, it could be your house. In finance, it could be the value of a stock, ETF, futures contract, etc. A long call is the mirror image of a long put so it would be insuring a short position (short stock, short another call), also with a premium and possibly a deductible.If you do not own the secondary asset then you are not insuring. You are speculating on them. – Bob Baerker Apr 18 '18 at 11:44
4

Black-Scholes is one of several pricing models that uses six variables to determine the theoretical value for an option. You mentioned five of them. You did not mention a dividend so it is assumed that there is none.

What's lacking in your question is an understanding of what a call option is, namely the right to buy an asset an agreed price on or before a particular date. If the option is European style (most indexes), they can only be exercised at expiration. American options (stocks, ETFs) can be exercised at any time.

In your example, the buyer of the call pays $234 (quoted at $2.34 per contract) for the right to buy the underying at $100, if so inclined. Should he prefer not to own it, he can sell the call at any time in the option market, perhaps for more, perhaps for less.

Puts are the mirror image of calls. The owner has the right to sell the underlying at the exercise/strike price, if so inclined.

In both cases, the owner of the option has the right. The seller has the obligation.

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.