Options pricing is the process of determining the value of an option contract. Options are financial derivatives that give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price and date. The value of an option is determined by various factors such as the price of the underlying asset, the strike price, the expiration date, and the volatility of the underlying asset.
Python is a popular programming language that is widely used in the field of finance, including options pricing. There are several libraries available in Python such as Scipy, Numpy, and Pandas that can be used to perform numerical computations, data analysis, and visualization.
One of the most widely used option pricing models is the Black-Scholes model. This model uses five inputs to calculate the value of an option: the price of the underlying asset, the strike price, the risk-free interest rate, the time to expiration, and the volatility of the underlying asset. The Black-Scholes model can be implemented in Python using the Scipy library's norm function to calculate the cumulative standard normal distribution.
Another popular option pricing model is the Binomial model. This model uses a lattice approach to simulate the possible price movements of the underlying asset. The model is based on the assumption that the price of the underlying asset can move up or down in discrete steps. The Binomial model can be implemented in Python using the Numpy library for array manipulation and the Pandas library for data analysis. Here's a Binomial example:
import numpy as np
def binomial_option_pricing(s, k, r, t, v, steps, option_type):
dt = t / steps
u = np.exp(v * np.sqrt(dt))
d = 1 / u
p = (np.exp(r * dt) - d) / (u - d)
stock_prices = s * (u ** np.arange(steps + 1)) * (d ** np.arange(steps + 1)[::-1])
stock_prices = stock_prices.reshape(-1, steps + 1)
if option_type == 'call':
option_prices = np.maximum(stock_prices - k, 0)
elif option_type == 'put':
option_prices = np.maximum(k - stock_prices, 0)
else:
raise ValueError("Invalid option type")
for i in range(steps - 1, -1, -1):
option_prices[:, i] = (p * option_prices[:, i + 1] + (1 - p) * option_prices[:, i]) * np.exp(-r * dt)
option_price = option_prices[0, 0]
return option_price
# Example usage
s = 100 # price of underlying asset
k = 105 # strike price
r = 0.03 # risk-free interest rate
t = 0.5 # time to expiration (in years)
v = 0.2 # volatility of underlying asset
steps = 1000 # Number of steps for the binomial tree
call_price = binomial_option_pricing(s, k, r, t, v, steps, 'call')
put_price = binomial_option_pricing(s, k, r, t, v, steps, 'put')
print("Call price: ", call_price)
print("Put price: ", put_price)
This program defines a binomial_option_pricing() function that takes in the price of the underlying asset (s), the strike price (k), the risk-free interest rate (r), the time to expiration (t), the volatility of the underlying asset (v), the number of steps for the binomial tree (steps) and the option type ('call' or 'put') as inputs. It then calculates the stock prices using a binomial tree, and based on the option type passed in, it calculates the option prices using the max function. Finally, it uses the risk-free interest rate
Monte Carlo simulation is another method that can be used to price options in python. This method uses random sampling to simulate the possible price movements of the underlying asset. The Monte Carlo simulation can be implemented in Python using the Numpy library's random number generation functions. See the example below:
import numpy as np
def monte_carlo_option_pricing(s, k, r, t, v, iterations, option_type):
# Generate random stock prices using geometric brownian motion
dt = t / iterations
prices = s * np.exp((r - 0.5 * v ** 2) * dt + v * np.sqrt(dt) * np.random.normal(size=iterations))
prices = np.insert(prices, 0, s) # Add the initial stock price to the array
prices = np.cumprod(prices) # Calculate the cumulative product of stock prices
if option_type == 'call':
option_prices = np.maximum(prices - k, 0) # Calculate call option prices
elif option_type == 'put':
option_prices = np.maximum(k - prices, 0) # Calculate put option prices
else:
raise ValueError("Invalid option type")
option_price = np.exp(-r * t) * np.mean(option_prices) # Calculate the average option price
return option_price
# Example usage
s = 100 # price of underlying asset
k = 105 # strike price
r = 0.03 # risk-free interest rate
t = 0.5 # time to expiration (in years)
v = 0.2 # volatility of underlying asset
iterations = 10000 # Number of iterations for the Monte Carlo simulation
call_price = monte_carlo_option_pricing(s, k, r, t, v, iterations, 'call')
put_price = monte_carlo_option_pricing(s, k, r, t,
When implementing option pricing models in Python, it is important to consider the assumptions and limitations of each model. For example, the Black-Scholes model assumes that the underlying asset follows a lognormal distribution and that the market is efficient. The Binomial model assumes that the underlying asset can only move up or down in discrete steps.
Here's an example of a Black-Scholes option pricing program in Python using the scipy.stats library:
from scipy.stats import norm
def black_scholes(s, k, r, t, v, option_type):
d1 = (np.log(s / k) + (r + 0.5 * v ** 2) * t) / (v * np.sqrt(t))
d2 = d1 - v * np.sqrt(t)
if option_type == 'call':
option_price = s * norm.cdf(d1) - k * np.exp(-r * t) * norm.cdf(d2)
elif option_type == 'put':
option_price = k * np.exp(-r * t) * norm.cdf(-d2) - s * norm.cdf(-d1)
else:
raise ValueError("Invalid option type")
return option_price
# Example usage
s = 100 # price of underlying asset
k = 105 # strike price
r = 0.03 # risk-free interest rate
t = 0.5 # time to expiration (in years)
v = 0.2 # volatility of underlying asset
call_price = black_scholes(s, k, r, t, v, 'call')
put_price = black_scholes(s, k, r, t, v, 'put')
print("Call price: ", call_price)
print("Put price: ", put_price)
This program defines a black_scholes() function that takes in the price of the underlying asset (s), the strike price (k), the risk-free interest rate (r), the time to expiration (t), the volatility of the underlying asset (v) and the option type ('call' or 'put') as inputs. It then uses the norm function from the Scipy library to calculate the cumulative standard normal distribution and uses it to calculate the call and put option prices. It raises an error if the option type is neither 'call' nor 'put'
It's important to note that the Black-Scholes model assumes that the underlying asset follows a lognormal distribution and that the market is efficient. Additionally, this model assumes that the risk-free interest rate is constant and known, volatility is constant and known, and the option can be exercised only at expiration.
This is just a basic example and can be further enhanced by adding more checks and handling exceptions. Also, this is just one of the many methodologies that can be used to price options, other models and methods such as Monte Carlo simulation, Binomial Tree, etc. can be used. Each model has its own assumptions and limitations and the choice of the model will depend on the specific use case.
Options pricing is a complex task that involves determining the value of an option contract. Python is a popular programming language that can be used to implement option pricing models such as Black-Scholes, Binomial, and Monte Carlo simulation. These libraries such as Scipy, Numpy, and Pandas provide the necessary tools to perform numerical computations, data analysis, and visualization. It's important to consider the assumptions and limitations of each model when implementing it.