Black Scholes Model
The Black Scholes Model is a mathematical formula used to derive the price of an option. It’s based on the value of certain key variables or inputs. These inputs include stock (or other asset) price, strike price, time to expiration, volatility, dividends (if any), and current interest rate.
The actual Black Scholes equation is fairly complex, but it isn’t necessary to understand all the mathematics behind the formula. What’s important is to understand what variables impact the price of an option and to what extent.
For instance, by understanding Black Scholes, you would realize that interest rates have a minimal impact on the price of an option but volatility may have a significant impact.
Although imperfect, Black Scholes gives a trader a theoretical value for an option to help determine if that option is worth buying or selling (underpriced or overpriced). There are several other variables to consider when trading options, but the Black Scholes theoretical value is a good starting point for analysis.
The Black Scholes model has made a huge impact on the entire options trading industry. Prior to this equation, there was no standard method for pricing options… it was mostly a lot of guessing. Once Black Scholes came about, it provided a solid guideline for what the price of an option should be.
Turning option trading into a science (as opposed to gambling) made it significantly more popular among traders and investors. In other words, the Black Scholes Model is one of the primary reasons the options industry is wildly successfully today.
Category: Options Trading Basics
