globaltrdr
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With The Fast Moving Markets And Other Innovations Effecting Options Trading Markets. What Are Your Views Toward The Black Scholes Model? Is It Outdated Or What?
Black scholes model outdated?
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Rhody Trader
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Black-Scholes wasn't long employed on the Street exactly as designed. Even still, it does remain the basis for a lot of options valuation work. After all, the basic elements of options prices don't change. It's still a question primarily of time, volatility, and the price of the underlying instrument, with interest rates tossed in.
Profitaker
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No, not even close. BS is to options what the internal combustion engine is to the car. There will always be fancy versions touted, but the underlying principle won't and hasn't changed.
A para taken from site below......
http://bradley.bradley.edu/~arr/bsm/model.html
There have been slight variations to the model to cater for things like dividends, interest rates.
After the Black and Scholes Model:
Since 1973, the original Black and Scholes Option Pricing Model has been the subject of much attention. Many financial scholars have expanded upon the original work.
In 1973, Robert Merton relaxed the assumption of no dividends.
In 1976, Jonathan Ingerson went one step further and relaxed the the assumption of no taxes or transaction costs.
In 1976, Merton responded by removing the restriction of constant interest rates. The results of all of this attention, that originated in the autumn of 1969, are alarmingly accurate valuation models for stock options.
So it has certainly not remained constant. Also see site below.......
http://www.hoadley.net/options/options.htm
http://bradley.bradley.edu/~arr/bsm/model.html
There have been slight variations to the model to cater for things like dividends, interest rates.
After the Black and Scholes Model:
Since 1973, the original Black and Scholes Option Pricing Model has been the subject of much attention. Many financial scholars have expanded upon the original work.
In 1973, Robert Merton relaxed the assumption of no dividends.
In 1976, Jonathan Ingerson went one step further and relaxed the the assumption of no taxes or transaction costs.
In 1976, Merton responded by removing the restriction of constant interest rates. The results of all of this attention, that originated in the autumn of 1969, are alarmingly accurate valuation models for stock options.
So it has certainly not remained constant. Also see site below.......
http://www.hoadley.net/options/options.htm
And most/all of the exchanges' mm's still use it in its basic form for quotes. The end-user can then do what he wishes. Leave alone.
While many of the underlying assumptions of the original models are questionable, many alternatives have limitations, eg lack of uniformity across strikes, time frames, volatility curves/skews/smiles. Further, I think most alternative derived prices still refer to the original for comparison.
Grant.
While many of the underlying assumptions of the original models are questionable, many alternatives have limitations, eg lack of uniformity across strikes, time frames, volatility curves/skews/smiles. Further, I think most alternative derived prices still refer to the original for comparison.
Grant.
if anything the options pricing has become more accurate over the years with high speed real time tweaks the brokers set the price very accurately. Why? Because to a degree options are self setting. As one extends the price on calls another is selling till an equilibrium is reached. This sets the IV. The market is pretty much in balance on these instruments and it has to be otherwise there is a gap which can be exploited and the market does not allow exploits for very long before they are closed. The small errors are usually covered in the spread leaving very little room to play with. The IV portion is pretty much set by the market speculators and this can later be seen via ATR on the history trail after its been and gone. I'm always amazed by the accuracy of ATM strikes days or weeks out and option pricing is mathematically sound in the weeks out time period. I lost count the amount of times i seen expiry land within 10 pips of ATM forecast. Beyond that fundies start to have an effect that cannot be priced in by math. In other words the market has to show an event far beyond that of the pricing model before any real money is made which is why many take on trades which are priced months out into the future based on a fundy "feeling". However option pricing is traditionally and still is used for asset protection and not really to be traded in there own right. The vast majority of options expire worthless. So if options are priced quite accurate and premiums offer fair market value what else can we use this information for? Well i tell you its one of the most powerful tools to use for spot trading because now the ATM is fair value it then allows spot to be traded knowing where we will almost certainly end up by next Friday. We can know use this information to accurately set levels of risk and stops placement and always have the option to make some pips versus an option that will struggle even to cover the premium. In addition lets take euro for example it peaked at 15450 last week which was my calculated ATM the week before. The spillage was a mere 14 pips! As calls would be in profit on 3 pm expiry over 15450 that would imply the premium fair value was wrong so to attempt to run spot higher would be foolish. Armed with this information i took exit at 15450 which happened to be dead right. This is no fluke you can do this week after week. Brokers don't use straight Black Scholes though they use derivative versions with a skew based on their client portfolio. It can be reverse engineered by using genetic modeling to fill in the missing gaps.
In the meantime if you can price options correctly even if you believe they are fair valuation then working spot will give you a nice edge especially when someone says i think cable is going down to 1.9200 by this friday you can see at a glance that is very very unlikely because you are armed with an accurate ATM strike.
This is in stark contrast where normally in option pricing one would be looking for unfair option pricing in an attempt to profit from it either from increasing or decreasing volatility.
BTW in not an expert I only been trading 8 years and a couple of years on options but thought this tid bit might come in handy.
In the meantime if you can price options correctly even if you believe they are fair valuation then working spot will give you a nice edge especially when someone says i think cable is going down to 1.9200 by this friday you can see at a glance that is very very unlikely because you are armed with an accurate ATM strike.
This is in stark contrast where normally in option pricing one would be looking for unfair option pricing in an attempt to profit from it either from increasing or decreasing volatility.BTW in not an expert I only been trading 8 years and a couple of years on options but thought this tid bit might come in handy.
Bolts,
Interesting post. However, I question your assertion regarding the predictive power of ATM options.
This may apply where the market is flat for relatively long periods but as of late, where a 200-300 plus point intra-day range is not unusual, the atm strike in the morning will be different from the ATM strike in the evening when the market has dived 300 points (and continues going south for a few more days).
Grant.
Interesting post. However, I question your assertion regarding the predictive power of ATM options.
This may apply where the market is flat for relatively long periods but as of late, where a 200-300 plus point intra-day range is not unusual, the atm strike in the morning will be different from the ATM strike in the evening when the market has dived 300 points (and continues going south for a few more days).
Grant.
First don't do this on daily the options are far too unstable. I'm talking about end of week options or even 2 weeks out is good. If you price it right even under current conditions on fx majors i have been able to price ATM's very accurately to within 20 pips most of the time.
Dont be afraid to price out for weekly either there is still 200 to 250 pips profit to be had out of a weekly bar right now on euro and double that on cable. To make this kind of profit using options would be difficult albeit the spot risk is always higher unless your selling options but when everything is priced at fair value no matter how may pips is covered in a week all depends if it met expectations.
Dont be afraid to price out for weekly either there is still 200 to 250 pips profit to be had out of a weekly bar right now on euro and double that on cable. To make this kind of profit using options would be difficult albeit the spot risk is always higher unless your selling options but when everything is priced at fair value no matter how may pips is covered in a week all depends if it met expectations.
A Dashing Blade
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Sorry, I don't get it (but I'd like to), what exactly is Bolts doing?
DB,
Bolts is referring to fx options (I was comparing index options - not necessarily a valid comparison). I haven't looked at fx iv's for years but I do remember they are relatively low, single to low teen figures. Further, I think he may also be looking at options which are close to expiry or short-dated options, eg Eurex does one-week expiry options.
So if USD/JPY atm options have a 10% iv with a week to expiry, and assuming a constant volatility, then one just extrapolates the closing range (not an exact science). Years ago I remember Reuters FX reports attributed particularly heavy buying/selling in spot as banks defending specific levels where otc options would kick in (barrier, one-touch options?). This could be used as a supporting factor.
Thgen again, I may be totally wrong (that would be a surprise, wouldn't it?).
Grant.
Bolts is referring to fx options (I was comparing index options - not necessarily a valid comparison). I haven't looked at fx iv's for years but I do remember they are relatively low, single to low teen figures. Further, I think he may also be looking at options which are close to expiry or short-dated options, eg Eurex does one-week expiry options.
So if USD/JPY atm options have a 10% iv with a week to expiry, and assuming a constant volatility, then one just extrapolates the closing range (not an exact science). Years ago I remember Reuters FX reports attributed particularly heavy buying/selling in spot as banks defending specific levels where otc options would kick in (barrier, one-touch options?). This could be used as a supporting factor.
Thgen again, I may be totally wrong (that would be a surprise, wouldn't it?).
Grant.
