Black-Scholes Model: What It Is, How It Works, and Options Formula (2024)

What Is the Black-Scholes Model?

The Black-Scholes model, also known as the Black-Scholes-Merton (BSM) model, is one of the most important concepts in modern financial theory. This mathematical equation estimates the theoretical value of derivatives based on other investment instruments, taking into account the impact of time and other risk factors. Developed in 1973, it is still regarded as one of the best ways to price an options contract.

History of the Black-Scholes Model

Developed in 1973 by Fischer Black, Robert Merton, and Myron Scholes, the Black-Scholes model was the first widely used mathematical method to calculate the theoretical value of an option contract, using current stock prices, expected dividends, the option's strike price, expected interest rates, time to expiration, and expected volatility.

The initial equation was introduced in Black and Scholes' 1973 paper, "The Pricing of Options and Corporate Liabilities," published in theJournal of Political Economy. Robert C. Mertonhelped edit that paper. Later that year, he published his own article, "Theory of Rational Option Pricing," in The Bell Journal of Economics and Management Science, expanding the mathematical understanding and applications of the model, and coining the term "Black–Scholestheory of options pricing."

In 1997, Scholes and Merton were awarded theNobel Memorial Prize in Economic Sciences for their work in finding "a new method to determine the value of derivatives." Black had passed away two years earlier, and so could not be a recipient, as Nobel Prizes are not given posthumously; however, the Nobel committee acknowledged his role in the Black-Scholes model.

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 six variables. These inputs are volatility, the price of theunderlying asset, thestrike priceof the option, the time until the expiration of the option, the risk-freeinterest rate, and the type of option (call or put). 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 of the underlying asset are normally distributed.
• The option is European and can only be exercised at expiration.

While the originalBlack-Scholesmodel 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 theex-dividenddate 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 is complicated and can be intimidating. Fortunately, you don't need to know or even understand the math to useBlack-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.

The Black-Scholes call option formula is calculated by multiplying the stock price by the cumulative standard normal probability distribution function. Thereafter, the net present value (NPV) of the strike price multiplied by the cumulative standard normal distribution is subtracted from the resulting value of the previous calculation.

In mathematical notation:

$\begin{aligned}&C = SN (d_1) - Ke ^{-rt} N (d_2) \\&\textbf{where:} \\&d_1 = \frac { ln ^ S_K + (r + \frac { \sigma^2_v }{ 2 } ) t }{ \sigma_s \sqrt { t } } \\&\text{and} \\&d_2 = d_1 - \sigma_s \sqrt { t } \\&\textbf{and where:} \\&C = \text{Call option price} \\&S = \text{Current stock (or other underlying) price} \\&K = \text{Strike price} \\&r = \text{Risk-free interest rate} \\&t = \text{Time to maturity} \\&N = \text{A normal distribution} \\\end{aligned}$​C=SN(d1​)−Ke−rtN(d2​)where:d1​=σs​t​lnKS​+(r+2σv2​​)t​andd2​=d1​−σs​t​andwhere:C=CalloptionpriceS=Currentstock(orotherunderlying)priceK=Strikepricer=Risk-freeinterestratet=TimetomaturityN=Anormaldistribution​

Volatility Skew

Black-Scholes assumes stock prices follow a lognormal distribution because asset prices cannot be negative (they are bounded by zero).

Often, asset prices are observed to have significant rightskewnessand some degree ofkurtosis (fat tails). This means high-risk downward moves often happen more often in the market than a normal distribution predicts.

The assumption of lognormal underlying asset prices should show that implied volatilities are similar for each strike price according to the Black-Scholes model. However, since the market crash of 1987, implied volatilities forat-the-moneyoptions have been lower than those furtherout of the moneyor far in the money. The reason for this phenomenon is the market is pricing in a greater likelihood of a high volatility move to the downside in the markets.

This has led to the presence of thevolatility skew. When the implied volatilities for options with the sameexpiration dateare mapped out on a graph, a smile or skew shape can be seen. Thus, the Black-Scholes model is not efficient for calculating implied volatility.

The Black-Scholes model is often contrasted against the binominal model or a Monte Carlo simulation.

See Also

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Benefits and Limitations of the Black-Scholes Model

Benefits

• Acts as a stable framework based on a defined method.

• Allows investors to mitigate risk by better understanding exposure

• May be used to devise strategies for creating a portfolio based on an investor's preferences.

• Streamlines and improves efficient calculating and reporting of figures

Limitations

• Does not take into consideration all types of options

• May lack cashflow flexibility based on the future projections of a security

• May make inaccurate assumptions about future stable volatility

• Relies on a number of other assumptions that may not materialize into the actual price of the security

Benefits of the Black-Scholes Model

The Black-Scholes model has been successfully implemented and used by many financial professionals due to the variety of benefits it has to offer. Some of these benefits are listed below.

• Provides a Framework: The Black-Scholes model provides a theoretical framework for pricing options. This allows investors and traders to determine the fair price of an option using a structured, defined methodology that has been tried and tested.
• Allows for Risk Management: By knowing the theoretical value of an option, investors can use the Black-Scholes model to manage their risk exposure to different assets. The Black-Scholes model is therefore useful to investors not only in evaluating potential returns but also in understanding portfolio weakness and deficient investment areas.
• Allows for Portfolio Optimization: The Black-Scholes model can be used to optimize portfolios by providing a measure of the expected returns and risks associated with different options. This allows investors to make smarter choices better aligned with their risk tolerance and pursuit of profit.
• Enhances Market Efficiency: The Black-Scholes model has led to greater market efficiency and transparency as traders and investors are better able to price and trade options. This simplifies the pricing process as there is a greater implicit understanding of how prices are derived.
• Streamlines Pricing: On a similar note, the Black-Scholes model is widely accepted and used by practitioners in the financial industry. This allows for greater consistency and comparability across different markets and jurisdictions.

Limitations of the Black-Scholes Model

Though the Black-Scholes model is widely used, there are still some drawbacks to the model; some of the drawbacks are listed below.

• Limits Usefulness: As stated previously, the Black-Scholes model is only used to price European options and does not take into account that U.S. options could be exercised before the expiration date.
• Lacks Cashflow Flexibility: The model assumes dividends and risk-free rates are constant, but this may not be true in reality. Therefore, the Black-Scholes model may lack the ability to truly reflect the accurate future cash flow of an investment due to model rigidity.
• Assumes Constant Volatility: The model also assumes volatility remains constant over the option's life. In reality, this is often not the case because volatility fluctuates with the level of supply and demand.
• Misleads Other Assumptions: The Black-Scholes model also leverages other assumptions. These assumptions include that there are no transaction costs or taxes, the risk-free interest rate is constant for all maturities, short selling of securities with the use of proceeds is permitted, and there are no risk-less arbitrage opportunities. Each of these assumptions can lead to prices that deviate from actual results.

What Does the Black-Scholes Model Do?

The Black-Scholes model, also known as Black-Scholes-Merton (BSM), was the first widely used model for option pricing. Based on certain assumptions about the behavior of asset prices, the equation calculates the price of a European-style call option based on known variables like the current price, maturity date, and strike price.

It does so by subtracting the net present value (NPV) of the strike price multiplied by the cumulative standard normal distributionfrom the product of the stock price and the cumulative standard normal probability distribution function.

What Are the Inputs for the Black-Scholes Model?

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

What Assumptions Does the Black-Scholes Model Make?

The original Black-Scholes model assumes that the option is a European-style option and can only be exercised at expiration. It also assumes that no dividends are paid out during the option's life, that market movements follow a random walk and cannot be predicted, that there are no transaction costs involved in buying the option, that the risk-free rate and volatility of the underlying are known and constant, and that the prices of the underlying asset follow a log-normal distribution.

What Are the Limitations of the Black-Scholes Model?

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, trading costs, or taxes can also lead to valuations that deviate from real-world results.

The Bottom Line

The Black-Scholes model is a mathematical model used to calculate the fair price or theoretical value. It provides a way to calculate the theoretical value of an option by taking into account the underlying asset's current price, the option's type, the option's strike price, the time remaining until expiration, the risk-free interest rate, and the volatility of the underlying asset. The Black-Scholes model has had a profound impact on finance and has led to the development of a wide range of derivative products such as futures, swaps, and options.