Options in an asset allocation model

I’m building an asset allocation model and I’m curious if there are different ways to treat options? Should I factor in what thier implied market price would be if exercised to determine my sector exposure, or just use the market price of the option itself?

You need to look at options in terms of delta. For instance, lets say you have an in-the-money option where delta is 1, stock price is $150 and strike price is $100. How much notional exposure do you have from this option?

The answer is $150. Since delta is 1, you need 1 share of stock to hedge the delta. So, holding this option is equivalent to holding one share worth $150.

Now, let’s say the stock price goes to $100. Delta is now about 0.5. You need 0.5 shares of stock to hedge this option. So now, your notional exposure is $50.

The answer to your question is related to the stock price. However, you must factor in delta in your calculation, not just use the stock price outright.

Additionally, you might want to consider implied volatility and dividends (option holders don’t get the dividends). This makes option positions not completely comparable to stock positions.