There are a number of variables that impact the pricing of options and hence, the ability of retail businesses to profit from specific products and sales. The major variable that impacts the pricing of options is the price of the underlying (Kilic, 2005). The absolute price of the option premium will undergo significant change dependent on the price of the underlying stock. The closer the difference between the strike price and the market price, the greater the rate of change in the premium price for the stock and therefore, the specific price of an option. The time to expiry of the product is also a major variable that impacts its ability to fluctuate up and down (Subramani, 2007). As the product approaches its specific expiry date, there is a greater chance of fluctuations in the underlying price and therefore, the price of the option. Further away from the expiry, there is more stability and watchful eyes as potential customers and clients monitor the price and make sound predictions on whether it will fluctuate up or down (Kilic, 2005). For example, when an investor purchases an option a longer time from its expiry, its price will be higher in contrast to closer to the time where the price of the product will be lower. Investors will normally wait until the last few moments of a stock and just before it gets sold. More bids are placed hence raising the price of the stock and essentially making it more competitive (Kilic, 2005).
Expected dividends for a particular stock or option also largely influence its pricing. If there is a larger expected dividend as a return to the original price of the option, than its price will not fluctuate as violently (Kilic, 2005). Whereas in contrast, an option that has a lower dividend will be more volatile and its price will have a greater likelihood of fluctuating up or down. In addition, its price will fluctuate closer to its expiry date as stipulated earlier in this paper (Subramani, 2007). This results from greater eagerness for investors to make a larger profit and return from the sale of a specific option. Since its return in dividends will be smaller, sellers rely on the last few moments of the option to make a larger profit and hence return.
In comparing the two major options of pricing models, the Black-Scholes Model and Binomial Model, major differences concern whether the particular option will pay out investors a substantial dividend. The Black-Scholes Model prices call options on a particular stock that does not pay a dividend. These are more volatile than dividend paying stocks (Kilic, 2005). The Black-Scholes Model provides some relative stability of pricing for stocks that do not pay out dividends and provides investors as well as retailers with a greater extent of certainty and also stability. As mentioned, stocks that do not pay out a dividend are more volatile and uncertain in nature (Subramani, 2007). The Black-Scholes Model also provides more clarity on these stocks for investors who are hesitant about their current and future direction. This model is also advantageous as it is quick and efficient and can quickly price a number of stock options to allow investors with a run down of pricing options prior to buying before the expiry date (Kilic, 2005).
The binomial model in contrast, focuses on the impact of the time to expiry on particular stock options. It is similar to the Black-Scholes option in that it provides more clarity on the potential stability of stock options and prediction of fluctuations closer to the time of expiry. It provides this stability by dividing the time to expiry into particular intervals where advice can be provided to stock investors such as buyers and sellers (Subramani, 2007). At each time interval, the binomial model provides calculations based on time to expiry and the price of the stock. It acknowledges that the price of the stock will increase closer to the time of expiry. At intervals further away from the time of expiry, the model will predict lower prices to potential buyers whereas throughout intervals closer to the time of expiry, it will predict higher prices to potential buyers (Subramani, 2007). It also calculates the volatility of the option at each interval and this also helps to determine a price at the time interval.
- Kilic, E. (2005). A Comparison of Option Pricing Models. Finecus, Retrieved from http://www.finecus.com/docs/option.pdf Accessed on 01 August 2015.
- Subramani, R. (2007). Factors Affecting pricing of an option. Accounting For Investments, Retrieved from http://accountingforinvestments.com/factors-affecting-pricing-of-an-option/ Accessed on 01 August 2015.