By now, you know that options allow you to create many different patterns of payoffs.  You can construct positions that allow you to profit from your information or beliefs, and you can also use options to hedge the payoffs from an existing position.  In either case, if you buy or sell an option, you will trade at what is called the option value or the option premium. 

How do you know what is a good price ?

Answering this question is the subject of what is known as Option Pricing Theory.  The basic version of this theory assumes a one-period world in which the current stock price can move to only two future values.  This is called the one-period binomial model, where "binomial" refers to the fact that there are only two possible future stock values.  You will learn many of the central concepts of option pricing theory using this simple model.  We then extend this model to cover many periods; this extension provides the foundation for studying the option pricing problem in continuous time.  The binomial approach was formalized by Cox, Ross, and Rubinstein (1979), while the continuous time approach is due to Merton (1974) and Black-Scholes (1973).

Figure 1.3 depicts the layout of how this book approaches the problem of Option Valuation.

Figure 1.3

Option Pricing Models and Applications