What is an Option Pricing Theory?

An option pricing theory, also known as an option pricing model, is any theory that seeks to determine the proper valuation of an option. In general, an option is an agreement that gives the owner the right to buy or sell a security or other property for a pre-determined amount, within a certain period of time. Because options are widely traded through exchanges, determining the right price for options is a desirable goal for traders. Also, since an option extends through a period of time that is agreed on at the time of its sale, it is important that the values for options be accurate and fair throughout this period. Any model that attempts to set accurate prices for options, using all available information, is an option pricing theory.

Options are sold on properties like commodities and stocks. There are two types of options, known as call and put options. Call options give the buyer the right to buy a property at a specified price throughout the period, so the buyer is betting the property will increase in value. Put options give the buyer the opportunity to sell a property at an agreed price, so the buyer is betting the property will decrease in value. Therefore, to arrive at a fair valuation of options, any option pricing theory will need to take into account past information about the property, as well as current prices, likely future performance, and the length of time the option lasts.

Each type of option pricing theory is a complex mathematical operation that includes these past, present and future indicators, along with some others, depending on the theory. The most commonly used option pricing theory is known as the Black-Sholes model, developed by Fisher Black and Myron Sholes in the 1970s. Many options traders rely heavily on the Black-Sholes model. Sholes and another contributor to the model, Robert Merton, won Nobel Prizes in Economic Science in 1990 for their work on the theory. It is sometimes criticized for heavy reliance on past performance, its complexity, and the fact that it is not especially useful for options with long periods that are not traded.

The binomial lattice model, or binomial option pricing model, is another type of option pricing theory. It is preferred by some because it takes into account more factors than the Black-Sholes model. Perhaps because of its record of past use, Black-Sholes remains the most widely used option pricing theory.