Stock Market Trading
On an option exchange, every 3rd Friday of the month is expiration day. A number of option series expire on this day.
At expiration all call options with a higher strike price than the expiration price of the underlying stock/currency or index will be worthless. All series with a lower strike price will have value and will be exercised. In the case of put options the opposite applies.
For all holders of call options it will be optimal when the value of the positions at expiration is as low as possible.
Options expiration date is the most important factor in calculating an options price:
- The Black Scholes formula is used to price a European style option by factoring in current stock price, strike price, time until expiration, level of interest rates, any dividends and the volatility of the underlying security.
- The binomial model is used to price American style options. The binomial model calculates a tree of stock prices for given time intervals within the expiration period of the option using the volatility of a stock and time to expiration to find out how much a stock will increase or decrease in value. This calculation gives all possible prices of a stock. Then, the option prices of the stock are calculated backwards, from expiration to present. These prices are obtained by using risk neutral valuation. Ultimately, we get one price for the option.