Black Scholes

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.