Restart to return home

__How
Do I Use the OPTION CALCULATOR?__

To the
left you can see three
primary buttons: **Restart**, ** Sensitivity** and **Analytics**.

**Restart** gets you back to the base case
ready for an option valuation/information extraction exercises. This
always gets you back to the main Calculator screen. This screen is
described in detail below.

**Sensitivity** lets you
see
how the option price responds to changes in important value drivers. You
can jump to the introduction to the Sensitivity functions by clicking on the
hypertext.

**Analytics** lets you ask
"what-if" questions.

In this lesson we focus on the Option Calculator that can be returned to at any time by clicking on Restart. If you are ready to learn how to use the Sensitivity and Analytics components you can reach these lessons by clicking either the Sensitivity or Analytics buttons.

Our first goal is to learn how to apply the calculator to solve some real world option pricing problems. By working through the following you will first become familiar with important terms associated with option contracts and concepts.

**Using the Option
Calculator (the Restart Button)**

The calculator is designed to let you quickly solve three types of problems:

i. Value real world option contracts

ii. Extract important implied volatility from option prices

iii. Compute hedge parameters.

**Understanding the
Screen**

**Calculate **To
solve the above problems you will click on the
button Calculate. If you are valuing an option the answer appears beside
this button in the display box titled Value. If you are computing the
Implied Volatility from an existing option price the answer appears in the
input box titled Volatility. If you are computing the Hedge Parameters
the answer appears in the display boxes titled Delta, Gamma, Vega and Theta.

**Inputs**

To solve problems of the above types (i.-iii.) requires that you enter the appropriate inputs into the calculator. For example, to value a stock option you will need to enter five to six inputs: underlying price, volatility, interest rate, time to maturity, option's strike price, and possibly the dividend yield (if the underlying pays a dividend over the life of the option).

You can enter any input manually or you can get the Option Calculator to automatically retrieve some of the inputs from the web for supported exchanges.

**Underlying
Price ** This is the current price of the underlying asset that the
option is defined on. For example, suppose you are working with an IBM
stock option. The underlying asset price is IBM's current stock
price.

You can get this
automatically from the web by entering the Stock Ticker code for IBM and then click on the button **Get
Underlying Quote. **

Now observe that IBM's price is automatically retrieved from the web. If you are dealing with a security that is not directly supported (i.e., not reported by the CBOE and other default sites) you can enter the information manually. To do so, simply click beside 50, hit the backspace key twice, and type in the price in decimals or fractions.

**Volatility **This
is the most difficult of the inputs into an option pricing problem. You
must estimate the annualized volatility of the underlying asset price
process. For stocks this is a number that is normally above 0.25.
Because this number is difficult to estimate you will spend time later
learning how to calculate Implied Volatility which will let you form the basis
of your volatility estimate. For now, you simply click inside the
Volatility box use the backspace key to erase the current number and then type
in a new number (e.g., 0.45).

**Interest
Rate **This is the current estimate of the default free interest rate
for interest rate that match (approximately) the time to maturity for an
option.

Suppose for example, you are valuing a US stock option that lasts for 3-months. Click on the drop down beside the label Bottom Window and select the Bloomberg Treasury.html address.

In the bottom window you will see Bloomberg's treasury page appear. By scrolling down you can read off the current 3-month Treasury yield. This will provide a first pass estimate of the risk free rate for your 3-month option or nearby maturity option.

**Maturity **This
is the annualized time to maturity left for the option. For example, if
the option has 95 day life before it expires and the year has 365 days then
the Maturity number equals 95/365 = 0.260274.

Option Calculator will compute this automatically for you once you select an expiration month. That is, for options reported by the default sites it will automatically compute the option's expiration date for you.

To select an expiration month use the drop down menu below the text box titled Option Symbol. Make sure you select an option maturity that is currently being traded. You can learn how to check which maturities are trading by clicking on symbols and contractual features.

**Strike Price
**You must enter the strike (or exercise) price of the option you wish to
value in this text box. If in doubt enter an integer that is an exact
multiple of 5 that is the closest to the current underlying asset's
price. This type of option trades frequently and is known as an
(approximately) at-the-money option.

To see the full list of symbols trading read symbols and contractual features.

**Dividend Yield**
If the underlying asset does not pay a dividends over the life of the option
(i.e., from present time until the option matures) then you can leave this
filed blank. Otherwise you can estimate the dividend yield of the
underlying.

To do this go to the bottom window, click on the drop down and scroll down until you see the web site finance.yahoo.com. Select this site and then enter IBM into the Symbol box on the Yahoo web site that now appears in the bottom window. Click on Get Quotes and then click on the Profile under More Information (you will need to scroll down to see this in the bottom window).

Once you click on Profile scroll down and you will see Dividend Yield under Dividends & Splits. For IBM this will be around 0.42. So enter this number into the text box beside the label Dividend Yield in the Calculator.

**Completed Inputs
for Option Pricing Problem**

This is all that is required to value an option. Clearly, the most difficult input is volatility and later you will learn how to get an accurate estimate for this input.

Next, you must check that you have specified the correct contractual variables.

If the following terminology makes little sense to you then first work through the lesson on terminology by clicking on what is an option?

**Final Selections**

First, are you valuing a put or a call? Select one by clicking beside Put or Call.

Second, are you valuing a European or American option. The vast majority of stock options are American style options.

Third, if you are valuing an option turn off Implied Volatility (i.e., it should have a blank box beside it).

**Aside:**
If you are computing the implied volatility from an actual option price you
would check this box. Computing implied volatility for a particular
strike price and maturity requires a current option. You can
automatically retrieve the correct option price by specifying the option
symbol, option style (put/call), strike price, and maturity and then clicking on the
button Get Option Quote. To read more about what the current contractual
features are for options trading on the underlying of interest click on symbols
and contractual features.

**Calculate Option's
Price**

Congratulations now you are ready to calculate the option's price so simply click on the button labeled Calculate.

OS Financial Trading System, PO Box 11356, Pittsburgh, PA 15238 USA, Phone 1-800-967-9897, Fax 1-412-967-5958, Email fts@ftsweb.com,

(C) Copyright 2000, OS Financial Trading System