Wednesday, August 8, 2012
The most popular option pricing model -- Black-Scholes -- is outdated and unreliable, for several reasons:
1. First, it was first published in 1973, when the public trading of options was in its primitive stages. Calls were available on only a handful of listed companies, and puts were not traded publicly at all. With this in mind, the model was a theory only and not based on any market statistics.
2. The model assumes European style expiration (positions can be exercised only on the last trading day). However, options on listed stocks are traded American style, meaning they can be exercised at any time. This changes the assumptions underlying the Black-Scholes model.
3. The model assumes no dividend yield. Options traders know that dividends play a major role in total return and cannot be ignored.
4. The model further assumes that valuation and income have to be compared to an assumed rate of risk-free interest. Under today's odd money market, is this even valid any more?
5. With online trading and Internet access to information, the world of 1973 is practically prehistoric in terms of information flow, transaction speed, and costs.
Although subsequent papers have tried to modify Black-Scholes to make it more in line with market realities,the basic theory has little to do with modern options pricing. An alternative method may split premium into three parts, two of which are specific and easily identified in advance. First is intrinsic value, the in-the-money point spread between current price and strike. This is an exact dollar value. Second is time value, which is also predictable and precise. It can be modeled and isolated so that the rat of time decay is known well in advance -- and it should be unaffected by proximity between strike and current value.
The final leg of value is implied volatility, also called extrinsic value. This is where all of the variables are found. These include the complex interaction between proximity of strike to value, and time to expiration. The calculation of implied volatility is further complicated by historic volatility of the underlined as well as current fundamental and technical volatility of the stock. This may be based on company-specific news or events, or on market-wide perceptions, right or wrong. To get a handle on the complexities of implied volatility in a quick and easy way, check
In other words, it is time for a different and more realistic pricing model.
Source Options expert and author Thomsett