Option pricing refers to the process of calculating the fair value of an options contract. The price of an option is determined by several factors, including the current market price of the underlying asset, the strike price, the time until expiration, the volatility of the underlying asset, and interest rates.
The most basic method for pricing options is the Black-Scholes model, which was developed in the 1970s. This model takes into account the above factors, and is widely used for pricing European-style options. American-style options, which can be exercised at any time before the expiration date, are typically priced using more complex models.
The Black-Scholes model uses several variables to determine the fair value of an option, including the current price of the underlying asset, the strike price, the time until expiration, the risk-free interest rate, and the volatility of the underlying asset. The model assumes that the underlying asset follows a log-normal distribution, which means that small changes in the price of the underlying asset have a proportional effect on the price of the option.
The Black-Scholes model produces a theoretical price for an option, but this price may differ from the actual market price due to various factors, such as market conditions and liquidity. Traders use the theoretical price as a starting point for negotiating the actual price of an option.
In summary, option pricing is the process of calculating the fair value of an options contract based on various factors, and the Black-Scholes model is a commonly used method for pricing options.