**What is the Black-Scholes option pricing model?**

The Black-Scholes option pricing model has been around since 1973 when Fischer Black and Myron Scholes released their research to the world. Since then the name Black-Scholes has been synonymous with option valuation.

**How does it work? **

The formula works by calculating the difference between the share price and the exercise price, taking into account the amount of time the option has until expiry, as well as a risk-free rate of return, and the volatility of the share price.

**Why does everyone use it?**

The Black-Scholes formula is useful because it allows users to estimate the value of an option with easily observable data in a fairly straightforward mathetical process. This compares to other option valuation methods which can require a number of different complex calculations to occur, which can be both time-consuming and difficult to process.

As such, Black-Scholes is seen as the starting point for any option valuation calculation as it is relatively simple, and the information required be quite easily obtained.

**What are its limitations?**

The formula uses a number of assumptions:

- The option will only be exercised at the end of its life
- That there exists a “risk-free” rate of return
- The returns are constant and continuous
- The share does not pay dividends

As a result, the price provided by the Black-Scholes formula is only ever a theoretical price, as the assumptions used are rarely ever seen in the real world. However, it does provide a useful approximation for an option’s value.

Contact Value Logic for assistance with your option valuation issues.