The Black-Scholes Model - A Scientific way to Value an Option

The Black-Scholes Model - A Scientific way to Value an Option

When we value a football bet, there is no way to say for certain if it is valued other than by the fact that the crowd seems to think so. The spread we end up with is a result of broadcasting different point spreads until all bets have been made. Prior to 1973, this is exactly how the options market worked. Traders had to throw out bids and offers based on what they felt a trade was worth. Because nobody really had a means to quantify the numbers, traders tended to bid low and offer high, which creates very large bid-ask spreads. Large spreads mean low volume so the market became very inefficient and never quite got off the ground.

Fortunately, that all changed in 1973 when Fisher Black and Myron Scholes created the Black-Scholes Option Pricing Model, which allowed traders to get a more scientific idea of what an option’s price should be. It is no surprise that this was the very year that the Chicago Board Options Exchange (CBOE) was created since there was now an objective way to readily determine the fair price of an option. And with this knowledge, traders were willing to bid higher and sell for less.

Despite the importance of the model, most option traders do not use it. They pick all their option trades based on directional beliefs. They feel the model is only a theoretical tool that has no place in the real world of option trading. Unfortunately, that is far from true. The Black-Scholes Model allows traders to gain access to one of the most important pieces of information before jumping into a trade - it allows traders to judge whether the price of an option reflects a good value.