6116 - 17.15 - Biomial trees - FINAL - 2009 Pricing stock options through the Binomial Tree Model Finance Assignment Tutor Dr Bart Vinck Students Andrew

6116 - 17.15 - Biomial trees - FINAL - 2009 Pricing stock...

This preview shows page 1 - 3 out of 8 pages.

Pricing stock options through the Binomial Tree Model Finance Assignment Tutor: Dr. Bart Vinck Students: Andrew Talla, Joshua Bukuru & Queen Bissiongol 2009
Image of page 1
Definition A stock option gives you the right, but not the obligation to buy (or sell) a specified number of shares of a stock (referred to as the underlying security) at a set price for a limited time period. The option can be to either buy the stock (a call option) or to sell it (a put option.) Call Option A call option gives the buyer the option to purchase an agreed quantity of a particular stock from the seller on or before an expiration date at a certain price, known as the strike price. The seller has to sell the stock if the buyer wants it by the expiration date. The buyer pays a fee (called a premium) for this right. The buyer benefits when the stock is moving up, bringing its value above the strike price. The option is then said to be 'In the Money.' On or before the expiration date, the buyer acquires the stock at the strike price and makes a profit by selling it. If the stock ends up lower than the strike price, the buyer is not under the obligation to buy. The risk for the buyer is limited to the premium. Call options are profitable when the market is booming. Put Option A put option is a contract that allows you to sell stock at a particular price (strike price) on or before an expiration date. The seller pays a premium to buy a put option. If the value of the stock falls and is lower than the strike price, you can buy the stock at the market price and make a profit because you can sell at the higher strike price. If the value of the stock rises, you are not under the obligation to sell the stock at the expiration date, and what you lose is the premium you have paid. Put options are profitable for the seller when the market is in decline. If you are selling a put option to somebody who holds stock, you are known as a "writer." The writer is someone who is bullish on the market and collects a premium. If the stock's value increases, the writer gains as the seller of the stock will not be inclined to sell it at the strike price, when the market value is higher. The premium is the writer's maximum gain, and having the option expire is the best case scenario. There are several styles of option categories, but the most common are European, and American; An American (American-style) option is an option contract that can be exercised at any time between the date of purchase and the expiration date. Most exchange-traded options are American-Style. For an American option, since the option may either be held or exercised prior to maturity, the value at each node is: Max (Binomial Value, Exercise Value). In contrast, a European (European-style) option is an option contract that can only be exercised on the expiration date. Investors in European options must ride the wave of price fluctuations until the maturity date. For a European option, there is no option of early exercise, and the binomial value applies at all nodes. This makes European options
Image of page 2
Image of page 3

You've reached the end of your free preview.

Want to read all 8 pages?

  • Fall '10
  • Bart Vinck
  • Options, Wikipedia, Strike price

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture

Stuck? We have tutors online 24/7 who can help you get unstuck.
A+ icon
Ask Expert Tutors You can ask You can ask You can ask (will expire )
Answers in as fast as 15 minutes