This week we will continue our discussion of how options are valued. I hope you had a great Independence Day weekend.
Terry
No discussion about option pricing can legitimately be made without mentioning the Black-Scholes model. This model was actually created by Robert C. Merton when he published a paper in 1973 where he coined the term "Black-Scholes" options pricing model and enhancing work that was published by Fischer Black and Myron Scholes. Merton and Scholes received the 1997 Nobel Prize in Economics for this and related work (Black had died before the award was given, although he was mentioned as a contributor by the Swedish academy.)
There are 5 components that determine the value of an option:
1. The price of the underlying stock
2. The strike price of the option
3. The time until the option expires
4. The cost of money (interest rates less dividends, if any)
5. The volatility of the underlying stock
The Black-Scholes model uses these components to determine the theoretical value of an option. This is the price that, given the 5 inputs, the option "should" be trading at.
Many market professionals base their entire trading strategy on comparing the actual option prices in the market with the theoretical values generated by the Black-Scholes model, hopefully buying "undervalued" (compared to the model) and selling "overvalued" options for the same underlying. If they buy and sell an equal number of options so that they don't care whether the stock goes up or down, they make their money when the market moves the market option prices toward the theoretical prices generated by the model. It is usually a successful tactic, although maintaining a totally neutral option position is quite difficult (and will be discussed in a later Option Trading Idea of the Week).
Over the years, a number of variations of the Black-Scholes model have been developed, but they are basically minor variations at best, and from my experience, the other models attempt to improve weaknesses in the basic model at the cost of inserting alternative weaknesses into their variation. I have long believed that none of the models do a particularly good job of determining put option prices (the models are much more accurate with call option pricing).
Next week, we'll continue our discussion of the most critical variable in the model - volatility.
Any questions? I would love to hear from you by email (terry@terrystips.com), or if you would like to talk to our guy Seth, give him a jingle at 800-803-4595 and either ask him your question(s) or give him your thoughts.
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I look forward to having you on board, and to prospering with you.
Terry
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