The key principles of option pricing are:
1. The underlying asset: The price of an option is related to the price of the underlying asset. In other words, the value of an option depends on the price of the asset it is based on.
2. Time to expiration: The longer the time to expiration, the greater the value of an option because there is more time for the price of the underlying asset to move in favor of the option holder.
3. Strike price: The difference between the strike price of an option and the price of the underlying asset is called the “intrinsic value.” The further in-the-money an option is, the greater its intrinsic value, which increases the price of the option.
4. Volatility: The more volatile the underlying asset, the greater the value of an option because there is a higher probability of the price of the asset moving in favor of the option holder.
These principles can be used to evaluate investment opportunities by analyzing the potential price movements of the underlying asset and determining the optimal strike price and expiration date for an option contract. This analysis can help investors make informed decisions about buying or selling options and can help them manage risk in their investment portfolios. Additionally, investors can use option pricing models, such as the Black-Scholes model, to calculate the theoretical value of an option and compare it to the market price to determine potential profit or loss.
