Black-Scholes Model

• The Black-Scholes model, aka the Black-Scholes-Merton (BSM) model, is a differential equation widely used to price options contracts
• The Black-Scholes model requires five input variables: the strike price of an option, the current stock price, the time to expiration, the risk-free rate, and the volatility
• Though usually accurate, the Black-Scholes model makes certain assumptions that can lead to prices that deviate from the real-world results
• The standard BSM model is only used to price European options, as it does not take into account that American options could be exercised before the expiration date

How the Black-Scholes Model Works

Black-Scholes posits that instruments such as stock shares or futures contracts, will have a lognormal distribution of prices following a random walk with constant drift and volatility. Using this assumption and factoring in other important variables, the equation derives the price of a European-style call option.

The Black-Scholes equation requires five variables. These inputs are volatility, the price of the underlying asset, the strike price of the option, the time until expiration of the option, and the risk-free interest rate. With these variables, it is theoretically possible for options sellers to set rational prices for the options that they are selling.

Furthermore, the model predicts that the price of heavily traded assets follows a geometric Brownian motion with constant drift and volatility. When applied to a stock option, the model incorporates the constant price variation of the stock, the time value of money, the option's strike price, and the time to the option's expiry.

Black-Scholes Assumptions

The Black-Scholes model makes certain assumptions:

• No dividends are paid out during the life of the option.
• Markets are random (i.e., market movements cannot be predicted).
• There are no transaction costs in buying the option.
• The risk-free rate and volatility of the underlying asset are known and constant.
• The returns on the underlying asset are log-normally distributed.
• The option is European and can only be exercised at expiration.

While the original Black-Scholes model didn't consider the effects of dividends paid during the life of the option, the model is frequently adapted to account for dividends by determining the ex-dividend date value of the underlying stock. The model is also modified by many option-selling market makers to account for the effect of options that can be exercised before expiration.

The Black-Scholes Model Formula

The mathematics involved in the formula are complicated and can be intimidating. Fortunately, you don't need to know or even understand the math to use Black-Scholes modeling in your own strategies. Options traders have access to a variety of online options calculators, and many of today's trading platforms boast robust options analysis tools, including indicators and spreadsheets that perform the calculations and output the options pricing values.

Limitations

The Black-Scholes model is only used to price European options and does not take into account that American options could be exercised before the expiration date. Moreover, the model assumes dividends, volatility, and risk-free rates remain constant over the option's life.

Not taking into account taxes, commissions or trading costs or taxes can also lead to valuations that deviate from real-world results.