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Black-Scholes Option Pricing Formula

In their 1973 paper, The Pricing of Options and Corporate Liabilities, Fischer Black and
Myron Scholes published an option valuation formula that today is known as the Black-
Scholes model. It has become the standard method of pricing options.

The Black-Scholes formula calculates the price of a call option to be:

C = S N(d1) - X e-rT N(d2)

where

C = price of the call option


S = price of the underlying stock
X = option exercise price
r = risk-free interest rate
T = current time until expiration
N() = area under the normal curve
d1 = [ e^(S/X) + (r + σ2/2) T ] / σ T1/2
d2 = d1 - σ T1/2

Put-call parity requires that:

P = C - S + Xe-rT

Then the price of a put option is:

P = Xe-rT N(-d2) - S N(-d1)

Assumptions

The Black-Scholes model assumes that the option can be exercised only at expiration.
It requires that both the risk-free rate and the volatility of the underlying stock price
remain constant over the period of analysis. The model also assumes that the
underlying stock does not pay dividends; adjustments can be made to correct for such
distributions. For example, the present value of estimated dividends can be deducted
from the stock price in the model.
The Black-Scholes model is used to calculate a theoretical call price (ignoring dividends paid
during the life of the option) using the five key determinants of an option's price: stock price,
strike price, volatility, time to expiration, and short-term (risk free) interest rate.

The original formula for calculating the theoretical option price (OP) is as follows:

Where:

The variables are:

S = stock price
X = strike price
t = time remaining until expiration, expressed as a percent of a year
r = current continuously compounded risk-free interest rate
v = annual volatility of stock price (the standard deviation of the short-term returns over one
year).
ln = natural logarithm
N(x) = standard normal cumulative distribution function
e = the exponential function

Black-Scholes option valuation: an overview


in plain language
The following article is expanded from a long post I made to the CompuServe Investor's Forum
in 1986. You can now find incredibly detailed and more accurate technical explanations of the
equation elsewhere on the web, but if you're new to it, this overview might be helpful to start
with because it uses plain language and avoids almost all of the mathematics.

Disclaimer: I do not consider option trading to be a viable route to profits in the financial
markets, whether one uses the Black-Scholes equation as a valuation guide or not. The reasons
are given in a previous article.

Introduction
The Black-Scholes option valuation formula attempts to calculate the fair economic value of an
option for both buyer and seller, the price at which (exclusive of commissions) both a buyer and
seller would, on average, break even if they repeated this trade many times. Thus, the calculated
price does not favor either the buyer or seller, so it is a price they can agree on. In real world
trading, it means that, on average, both the buyer and seller will lose money on the transaction,
by the amount of the commissions they paid. The valuation model uses probability theory,
discounted cash flows, and expected value calculations.

The model assumes:

• That the underlying stock price will fluctuate in the manner of a random walk. It will go
up sometimes and down sometimes, with small moves in either direction being very
likely and large moves in either direction being very unlikely.
• That the actual direction the stock will move during the holding period is not predictable,
by anyone, using any prediction method.
• That the volatility of a particular stock, the amount by which its price fluctuates during a
given time interval, is a stable measurement for that stock. That is, one can expect that
stock to exhibit the same volatility in the future that it has had in the past. (This
assumption is often incorrect.)

A summary of the Black-Scholes method might read like this:

Our stock has a characteristic volatility that we can expect it to exhibit during the life of our
option. Although we cannot predict the future price of our stock, we can (from the volatility)
calculate the statistical probability that on the option's expiration date the stock will have reached
or exceeded each possible target price. At each target price, the option will have a knowable
value which is its intrinsic value, the amount by which it is in the money.

Because we know each possible outcome of this situation (the various target prices), and because
we know the statistical likelihood of each outcome, and because we know what our return will be
from each of the possible outcomes (the option's value), we have enough information to calculate
the expected value of this option by using a payoff table.

The actual return we get this time might not be this average value, but if we were to repeat this
situation many times, this would be the average return of all those times.
In very simple terms, it is similar to this: if we are about to flip a coin, we have no way to predict
whether it will come up heads or tails, but we do know that it will come up heads 50% of the
time and tails 50% of the time. That is useful information even if it does not allow us to predict
the result of this one coin toss. For example, if we will earn $1 for each head but lose $10 for
each tail, the 50/50 statistic tells us that we should not play this game because we will lose badly
at it. On average, we will lose $4.50 with every toss. How to calculate this is shown below.

Why the stock's volatility is important


Let's use a concrete example, a $50 stock that on average fluctuates 2% per day.

Based on its historical volatility, its price tomorrow will be, with a 67% probability, between $49
and $51, and it is slightly more likely to be above $50 than below it.

1. The best single guess about tomorrow's price is that it will be the same as today's,
midway within the predicted range.
2. It might make its full 2% ($1.00) move in either direction, but that is slightly less likely.
3. It might even make a $10 move in either direction, but that is even less likely.
4. And so on. The larger the move, the less likely it is.

A big move on one day might be offset by a big move in the other direction the next day, or by
small moves on subsequent days, but on average, this stock fluctuates about 2% per day. The 2%
historical volatility figure makes it possible for us to estimate the range of prices within which
this stock will tend to stay over a given day, week, month, or year.

A low volatility stock will stay within a narrow range. A high volatility stock will tend to wander
farther, in either direction, from its current price, making its put and call options theoretically
more valuable because the stock price is more likely to reach extremes.

Payoff Table
A payoff table or decision matrix is a way of estimating the expected value of a situation that has
multiple possible outcomes. Each possible outcome has a probability of occurring and an
associated payoff that will result if it does occur. The payoff table calculates the average
expected return from the situation. The situation won't return that exact amount each time, but if
you encounter that situation many times, that will be the average return you get from it.

Examples

If something will return $20 and the probability of it happening is 100%, then the expected value
is $20. The calculation is easy. It is:

100% x $20 = $20


If another situation returns $20, but there is only a 50% chance of it happening, and there is a
50% chance of it returning nothing, then the expected value is cut in half, as follows, to $10:

ProbabilityxReturn=Expected Value (Average return)


50% x$20 =$ 10
50% x$ 0 =$ 0
100% total $ 10 Expected Value

As applied to a stock

If the stock is now at 50 and its historical volatility is 2% per day, then there is a statistical
method (incorporated into the Black-Scholes equation) for estimating the probability that the
stock will reach (for our simple example) each of the prices 40, 45, 50, 55, 60 at a given date
(our expiration date), and we know what the value of the option will be on that date because at
expiration an option has exactly its intrinsic value (the amount by which it is in the money).

We can therefore create a payoff table, using a $50 call option, like this. Note that the
probabilities reflect that the most likely price is the current price of $50, and extreme prices in
either direction are increasingly unlikely, as described above:

Stock
ProbabilityxOption Value=Expected Value
Price
40 10% x$ 0 =$ 0.00
45 20% x$ 0 =$ 0.00
50 40% x$ 0 =$ 0.00
55 20% x$ 5 =$ 1.00
60 10% x$ 10 =$ 1.00
100% total $ 2.00 Expected Value

In this simplified table, it appears that the fair value of the call to a buyer should be $2.00, but
that will be its value in the future, and we are buying it now, so we discount it to present value
using, for example, the interest rate on a T-Bill of the same time period as the expected holding
period of our option. So let's say we come up with $1.95 (just guessing).

Dividends
The basic Black-Scholes model assumes that the stock pays no dividends. However, some stocks
do pay dividends, and dividends do affect the prices of options.

The morning a stock goes ex-dividend, its price is dropped by the amount of the dividend. The
lowering of the price now also lowers the price projections into the future. Because the stock's
projected price is lower than it would have been, a dividend decreases the value of call options
(because the stock is less likely to be above the call's strike price) and increases the value of put
options (because the stock is more likely to be below the put's strike price).
Various refinements of Black-Scholes attempt to take these dividends into account. One
approach is to subtract the amount of the dividend from the current stock price before doing the
calculation (giving a lower price to start from). Since the dividend will be paid in the future, it is
not the actual amount of the dividend that is used, but the present value of it.

Expiration date
So far, the only date referred to is the expiration date. The Black-Scholes model only concerns
itself with that date. It does not concern itself with the probability that a stock will reach or
exceed a given price at some point during the intervening time, but only with the probability that
it will be at or above (or below, for puts) that price at the expiration date. It makes the
assumption that options are held to expiration. This is how European style options work, but it is
not how American style options work.

Valuing put options


To use the Black-Scholes formula for put options you must incorporate a routine to calculate the
price of an equivalent "synthetic put", which involves selling the stock short and buying a call
option on it. Because this can be less expensive than buying a put option, the prices of real puts
are driven down to the values of their equivalent synthetic puts. Without the synthetic put (also
known as "conversion put") calculation, the Black-Scholes formula overvalues puts and makes
all traded puts appear to be undervalued.

Trading strategy implied by Black-Scholes


The only strategy that seems to be implied by the Black-Scholes model is that of buying
undervalued options (or selling overvalued ones) and holding them to expiration even in the face
of any and all apparent setbacks in the position, trusting that the stock's historical volatility
characteristic will be fulfilled over the longer term to raise the option's market value to equal the
"fair value" that you calculated before you bought it. The goal would be to take advantage of a
temporary market inefficiency to purchase the stock's volatility at a bargain rate.

This is no formula for riches. Since the computed fair value reflects only a breakeven
proposition, your expected profit is limited to the amount that it was undervalued when you
bought it minus your in and out commissions.

Volatility calculations
The Black-Scholes formula requires as one of its inputs the stock's volatility, the "annualized
standard deviation of the underlying stock price's daily logarithmic returns".

I've created a volatility calculator. In addition to calculating historical volatility from a price
history you provide, it describes the calculation, has links to articles with greater detail, and
shows how it compares against other easier methods that were once common.
There was a time when one could only get the volatility estimate (or the historical price data
necessary for computing it) from expensive subscription services, so various alternative formulas
were in use.

Even today, volatility computation is a field of study in its own right. With the discovery (hardly
a surprise) that volatility is not as stable as the Black-Scholes model assumes, there are
alternative calculations that attempt to predict more precisely what the volatility is likely to be
during the specific holding period. For example, a weighted volatility might be used, with values
from recent weeks weighted more heavily than those from longer ago.

The different calculation methods can produce quite different estimates. If the volatility
calculation is critical, and if no method is definitive and universally accepted, which do you
trust?

This brings us to a real life truth: A thing is worth what anyone is willing to pay for it at a
particular time, regardless of what any model says it is supposed to be worth. If you cling
steadfastly to the Black-Scholes valuation model, or to one particular volatility calculation
method, but other people are willing to pay more than the "fair price" that your model calculates,
then the other traders, using their valuation methods, will drive prices to the valuations calculated
by their methods (or lack of method).

Nonetheless, if you want to actually find economically undervalued or overvalued options using
the Black-Scholes formula, you must use the true volatility calculation that it requires or one of
the newer alternatives that adheres completely to its intent but attempts to improve the quality of
the estimate.

If you want to get the estimated "normal" price of an option, there are other valuation methods
besides Black-Scholes that take different approaches.

In 1987, it seemed that option traders tended to accept under- or over-valuations as conditions of
a particular option series that they expected to remain fairly constant. If they had to buy at an
overvaluation, they'd expect to sell at one, too, when that time came.

That approach treats options as independent instruments (which they are) that have their own
supply/demand characteristics independent of those of the underlying stock (which also is often
the case), and whose prices can therefore stray significantly from valuations calculated by Black-
Scholes or other models (which they often do).

Despite its attempt at mathematical precision for option valuation, for Black-Scholes the devil is
in the details of the volatility calculation and in the market realities of the trading floor. It is a
precise mathematical formula which requires an input value that is impossible to determine
precisely.

Nonetheless, because its principle seems sound, many traders do use Black-Scholes valuation as
a guide to pricing.
Black-Scholes Model - Definition

A mathematical formula designed to price an option as a function of certain variables-generally stock


price, striking price, volatility, time to expiration, dividends to be paid, and the current risk-free
interest rate.

Black-Scholes Model - Introduction

The Black-Scholes model is a tool for equity options pricing. Prior to the development of the Black-
Scholes Model, there was no standard options pricing method and nobody can put a fair price to
charge for options. The Black-Scholes Model turned that guessing game into a mathematical science
which helped develop the options market into the lucrative industry it is today. Options traders
compare the prevailing option price in the exchange against the theoretical value derived by the
Black-Scholes Model in order to determine if a particular option contract is over or under valued,
hence assisting them in their options trading decision. The Black-Scholes Model was originally created
for the pricing and hedging of European Call and Put options as the American Options market, the
CBOE, started only 1 month before the creation of the Black-Scholes Model. The difference in the
pricing of European options and American options is that options pricing of European options do not
take into consideration the possibility of early exercising. American options therefore command a
higher price than European options due to the flexibility to exercise the option at anytime. The classic
Black-Scholes Model does not take this extra value into consideration in its calculations.

Black-Scholes Model Assumptions

There are several assumptions underlying the Black-Scholes model of calculating options pricing. The
most significant is that volatility, a measure of how much a stock can be expected to move in the
near-term, is a constant over time. The Black-Scholes model also assumes stocks move in a manner
referred to as a random walk; at any given moment, they are as likely to move up as they are to
move down. These assumptions are combined with the principle that options pricing should provide no
immediate gain to either seller or buyer.

The exact 6 assumptions of the Black-Scholes Model are :

1. Stock pays no dividends

2. Option can only be exercised upon expiration

3. Market direction cannot be predicted, hence "Random Walk"

4. No commissions are charged in the transaction

5. Interest rates remain constant


6. Stock returns are normally distributed, thus volatility is constant over time

As you can see, the validity of many of these assumptions used by the Black-Scholes Model is
questionable or invalid, resulting in theoretical values which are not always accurate. Hence,
theoretical values derived from the Black-Scholes Model are only good as a guide for relative
comparison and is not an exact indication to the over or under priced nature of a stock option.

Black-Scholes Model Inputs

The Black-Scholes model takes as input current prices, the option's strike price, length of time until
the option expires worthless, an estimate of future volatility known as implied volatility, and risk free
rate of return, generally defined as the interest rate of short term US treasury notes. The Black-
Scholes Model also works in reverse: instead of calculating a price, an implied volatility for a given
price can be calculated. Implied Volatility is commonly calculated using the Black-Scholes Model in
order to plot the Volatility Smile or Volatility Skew.

The mathematical characteristics of the Black-Scholes model are named after 5 greek letters used to
represent them in equations; Delta, Gamma, Vega, Theta and Rho. These are now passionately known
to option traders as the "Greeks".

Known Problems Of The Black-Scholes Model

First, the Black-Scholes Model assumes that the risk-free rate and the stock's volatility are constant.
This is obviously wrong as risk free rate and volatility fluctuates according to market conditions.

Second, the Black-Scholes Model assumes that stock prices are continuous and that large changes
(such as those seen after a merger announcement) don't occur.

Third, the Black-Scholes Model assumes a stock pays no dividends until after expiration.

Fourth, analysts can only estimate a stock's volatility instead of directly observing it, as they can for
the other inputs.

Fifth, the Black-Scholes Model tends to overvalue deep out-of-the-money calls and undervalue deep
in-the-money calls.

Sixth, the Black-Scholes Model tends to misprice options that involve high-dividend stocks.

To deal with these limitations, a Black-Scholes Model variant known as ARCH, Autoregressive
Conditional Heteroskedasticity, was developed. This variant replaces constant volatility with stochastic
(random) volatility. A number of different models was developed afterwhich like the GARCH, E-
GARCH, N-GARCH, H-GARCH, etc, all incorporating ever more complex models of volatility. However,
despite these known limitations, the classic Black-Scholes model is still the most popular with options
traders today due to its simplicity.
Alternative to the Black-Scholes Model

As the Black-Scholes Model does not take into consideration dividend payments as well as the
possibilities of early exercising, it frequently under-values Amercian style options. Let's remember that
the Black-Scholes model was initially invented for the purpose of pricing European style options. As
such, a new options pricing model called the Cox-Rubinstein binomial model. It is commonly known as
the Binomial Option Pricing Model or simply, the Binomial Model was invented in 1979. This options
pricing model was more appropriate for American Style options as it allows for the possibility of early
exercise.

The Black-Scholes Formula Is:

C0 = S0N(d1) - Xe-rTN(d2)

Where:
d1 = [ln(S0/X) + (r + σ2/2)T]/ σ √T

And:
d2 = d1 - σ √T

And where:
C0 = current option value
S0 = current stock price
N(d) = the probability that a random draw from a standard normal distribution will be less than (d).
X = exercise price
e = 2.71828, the base of the natural log function
r = risk-free interest rate (annualized continuously compounded rate on a safe asset with the same
maturity as the expiration of the option; usually the money market rate for a maturity equal to the
option's maturity.)
T = time to option's maturity, in years
ln = natural logarithm function
σ = standard deviation of the annualized continuously compounded rate of return on the stock

Even though the original Black-Scholes Model do not take dividends into consideration, an extension of
the Black-Scholes Model proposed by Merton in 1973 alters the Black-Scholes model in order to take
annual dividend yield into consideration. This model is not as widely used as the original Black-Scholes
Model as not every company pays dividends.

Here's the Black-Scholes Model for Dividend Stocks formula :

C0 = Se-dTN(d1) - Xe-rTN(d2)

Where:
d1 = [ln(S0/X) + (r - d + σ2/2)T]/ σ √T

And:
d2 = d1 - σ √T

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