# Option trading model

By using the Black Scholes pricing model, it's possible, theoretically, to determine whether the trading price of an option is higher or lower than it's true value: The Black Scholes pricing model is based on a mathematical formula and that formula uses a number of variables or inputs to calculate a fair value for an option.

These variables are known as the inputs to the model and they are as follows:. The model also relies on several underlying assumptions for it to work. These assumptions are as follows:. It should be reasonably obvious that some of these assumptions aren't always going to be valid, and it's very important to recognize this because, it means that there is a distinct possibility that the theoretical values calculated using the Black Scholes model may not be accurate.

There can be no doubt that the development of the Black Scholes pricing model helped make options trading more viable in the eyes of investors, because it helped to change the idea that valuing options was little more than a guessing game.

However, there are a couple of key points you should be aware of. First, it isn't absolutely necessary to fully understand the mathematical formula behind the pricing model to be successful at options trading and it's not even necessary that you use it at all. If you do wish to use it though, you will probably find it easier to use one of the many Black Scholes model calculating tools on the internet rather than carrying out the calculations yourself. You will find that a number of online brokers include such a calculating tool for their customers to use.

Second, it should be noted that it should never be considered a precise indicator of the true value of an option, because there are some problems with the assumptions that underpin the model. For example, it assumes that interest rates and the volatility of the underlying security will remain constant during the period of the contract, and this is unlikely to be the case. It also doesn't take into account the fact that some stocks pay dividends, nor the extra value that American style options have because the holder of them is able to exercise them at any point.

There are, however, variants of the Black Scholes model that can be applied to factor in such issues. If you do plan on using the model as part of your trading strategy, then we strongly suggest that you don't rely upon it to return exact values, but rather theoretical values. These theoretical values can then be used for the purposes of comparing options to assist you in determining what trades you should be making. You could also use the model to help decide whether a potential trade you have identified through other methods is likely to be a successful trade or not.

In summary, the Black Scholes pricing model has played a notable part in how the options market and options trading have developed and it certainly still has its uses to traders. You should, however, be fully aware of its limitations and never be entirely dependent on it.

The Black Scholes Model The Black Scholes pricing model is partially responsible for the options market and options trading becoming so popular.

The following topics are covered: Section Contents Quick Links. Purpose As we have mentioned above, prior to the model it was very difficult for an investor to determine whether or not an option was priced correctly, and therefore whether or not it represented good value. These variables are known as the inputs to the model and they are as follows: As we have mentioned above, prior to the model it was very difficult for an investor to determine whether or not an option was priced correctly, and therefore whether or not it represented good value.

A big part of successful investing and trading is finding opportunities where an asset is underpriced or overpriced and then trading it accordingly. Because this wasn't really possible with options, the market wasn't particularly favored by investors and traders and it was considered very risky.

The Black Scholes formula was developed to calculate an economic value for options that is fair to both the buyer and seller. In theory, if options were bought and sold repeatedly at the price set by this model, then buyers and sellers would both break even on average: The idea behind the formula is that it's possible to create a perfect hedging situation through combining options contracts and the underlying security, assuming that the contracts are priced correctly.

Basically, the theory proposed that there's only one truly correct price for an option, and that price can be calculated mathematically. In practice, the price is affected by many factors, including demand and supply, and because of this, options may not always be priced correctly.

By using the Black Scholes pricing model, it's possible, theoretically, to determine whether the trading price of an option is higher or lower than it's true value: The Black Scholes pricing model is based on a mathematical formula and that formula uses a number of variables or inputs to calculate a fair value for an option.

These variables are known as the inputs to the model and they are as follows:. The model also relies on several underlying assumptions for it to work. These assumptions are as follows:. It should be reasonably obvious that some of these assumptions aren't always going to be valid, and it's very important to recognize this because, it means that there is a distinct possibility that the theoretical values calculated using the Black Scholes model may not be accurate. There can be no doubt that the development of the Black Scholes pricing model helped make options trading more viable in the eyes of investors, because it helped to change the idea that valuing options was little more than a guessing game.

However, there are a couple of key points you should be aware of. First, it isn't absolutely necessary to fully understand the mathematical formula behind the pricing model to be successful at options trading and it's not even necessary that you use it at all. If you do wish to use it though, you will probably find it easier to use one of the many Black Scholes model calculating tools on the internet rather than carrying out the calculations yourself. You will find that a number of online brokers include such a calculating tool for their customers to use.

Second, it should be noted that it should never be considered a precise indicator of the true value of an option, because there are some problems with the assumptions that underpin the model. For example, it assumes that interest rates and the volatility of the underlying security will remain constant during the period of the contract, and this is unlikely to be the case. It also doesn't take into account the fact that some stocks pay dividends, nor the extra value that American style options have because the holder of them is able to exercise them at any point.

There are, however, variants of the Black Scholes model that can be applied to factor in such issues. If you do plan on using the model as part of your trading strategy, then we strongly suggest that you don't rely upon it to return exact values, but rather theoretical values. These theoretical values can then be used for the purposes of comparing options to assist you in determining what trades you should be making.