Stock option trader black scholes model
Most options traders have heard of the Black Scholes Model but few really know much about it. Following are some key bullet points about the model, its use and history:. Merton published a follow up paper further expanding the understanding of the model. Merton and Scholes stock option trader black scholes model the Nobel Prize for their work. Fisher Black was ineligible because Nobel prizes are not awarded posthumously. Main Stock option trader black scholes model — The main contribution of the Black Scholes model was the recognition that two parties with different expectations for the performance of a stock could still agree on a fair price for the option given that it was traded.
The key factor in the valuation was the volatility of the stock. Expectation does not enter into it. Of the listed factors, only Volatility is not known with a high degree of certainty. Volatility is also the most important factor. It should also be mentioned that for stocks which pay dividends the dividends and ex-dividend date are also factors which effect the valuation of options. The original Black Scholes paper only considered call options which did not pay dividends.
However other researchers have added various methods for valuing options with dividends. Usage — The original usage of the model was to calculate a stock option trader black scholes model value for a call option. The practitioner would plug in a value for each of the main stock option trader black scholes model of the model and it would calculate the fair value.
The key to using the model has always been to come up with a good estimate of future volatility. The goal of a trader is to buy an option below its fair value and sell it if it is above. Key Model Assumptions — One important assumption made in the Black Scholes model is that the stock price path follows a log normal random walk.
To a large extent this price distribution is a fair model of stock price behavior. However many have pointed out the the distribution of the tails of the stock price stock option trader black scholes model are fatter than the tails of the log normal.
Estimating Volatility — Most practitioners estimate volatility by calculating the log normal standard deviation of the stock over some recent time period. Then they take the recent volatility and extrapolate it going forward.
Some make adjustments based on whether they believe volatility will rise or fall in the future. Implied Volatility — In the beginning of the model people used it to calculate fair value. However people quickly realized that one could run the model backwards. This is called Implied Volatility and can be understood as the volatility implied by the current options price.
A high Implied Volatility can be understood to be a high price. A low one is a low priced option. The Skew — There usually are many options traded on a given stock, each with its own implied volatility. Rarely are they all exactly equal. Most of the time options at different strikes show a fairly smooth curve based on the strike. This curve is called the skew and sometimes affectionately referred to as the smile.
Thus strike prices that are far away from the current price of the stock usually exhibit the largest skew. Smart traders look for deviations from the skew stock option trader black scholes model individual options which may indicate mispricing. Enter your email address.