SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

Fatal Flaws in Black-Scholes


Is the Black-Scholes pricing model of options accurate? Or even close to accurate? A very interesting study conducted by Sibson Consulting was cited in an article on the topic (Tim Reason, “The Holes in Black-Scholes,” CFO Magazine, March 1, 2003).

The study revealed that only 3% to 5% of issues fell within acceptable ranges predicted by Black-Scholes. That is dismal.
 

The question of reliability is only one of two question, the second being whether or not a pricing formula is necessary to time trades. Because options are derivatives of the underlying security, it makes more sense to time trades based on historical volatility combined with strongly confirmed technical signals.


Shunning implied volatility and Black-Scholes is a heretical view about options, but it simply makes sense. Black-Scholes is so full of holes that the formula is unreliable, and the logic of this is evident. Fischer Black himself identified nine specific problems with the original formula 15 years after its publication. His article, “The Holes in Black Scholes,” highlighted nine flawed assumptions. These flaws were further augmented in a paper published by EspenGaarderHaug and Nassim Nicholas Taleb in the Journal of Economic Behavior and Organization, entitled "Options traders use (very) sophisticated heuristics, never the Black-Scholes-Merton Formula." Link to this article at http://tinyurl.com/d5fynms

Among the nine flaws were:

  1. focus on European exercise only,
  2. no allowance for dividends,
  3. calculation for calls only, and not for puts),
  4. assumption that option profits are not taxed,
  5. no transaction fees are applied,
  6. interest rates do not change over time,
  7. trading is continuous and no price gaps occur,
  8. price movement is normally distributed,
  9. volatility does not change over the life of an option.


The last two assumptions deserve further discussion. The idea that normal distribution can be applied to option pricing is untrue. Influences such as earnings surprises, mergers, rumors, and current news all affect prices. The flaw in this assumption was well documented by Sheldon Natenberg in Option Volatility and Pricing, pages 400-401 (1994).

The most serious flawed assumption of all is the last one listed, that volatility is a constant. Every trader knows that this is far from the truth. Volatility changes daily, often significantly. In addition, as expiration approaches, volatility collapse throws the whole Black-Scholes model into disarray. Even delta and gamma become unreliable toward the end of the option’s life. This is well documented in Jeff Augen’s book, Trading Options at Expiration (2009).

Despite the academic love of Black-Scholes, it is indisputable that it cannot be applied to identify bargain-priced options. It is just too flawed. This is heretical, but in debating this with other options traders, how many do you know who base their timing on Black-Scholes?

             

For those intent on using this formula, it is duplicated below.

 

image.png

                                             

For anyone interested in checking the formula against their trades, a n online tutorial in the use of Black-Scholes is found at http://www.macroption.com/black-scholes-excel/ and a simplified Excel spreadsheet can be downloaded at www.stern.nyu.edu/~igiddy/spreadsheets/black-scholes.xls.

Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Publishing as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.

 

 

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • Expiration Short Strategies

    Some traders have entered the options arena by selling exceptionally long-term contracts. The rationale for this is based on dollar amounts. A 24-month contract may yield an impressive dollar amount, but is it the best net return? It is not.

    By Michael C. Thomsett,

    • 0 comments
    • 46 views
  • Should You Finance or Pay Cash for a Home?

    When buying a home, individuals who have accumulated enough wealth to pay cash or make a substantial down payment have a decision to make. Take advantage of record low interest rates and lock in a 30-year mortgage for around 2.5%? Or pay cash and make payments to yourself by investing the savings?

    By Jesse,

    • 0 comments
    • 105 views
  • Implied Volatility Collapse

    The key ingredient on expiration Friday is volatility collapse. At the beginning of that last trading day, there are more than 6 hours of trading yet to go. However, there are 38 hours left before expiration on Saturday. When volatility is high, OTM options are most likely to be overpriced.

    By Michael C. Thomsett,

    • 0 comments
    • 204 views
  • Trading Volatility: Why It Isn’t Always a Bad Thing

    Volatility is still widely misunderstood — and feared — by novice traders. As someone lacking in trading knowledge and experience, you often hear and believe horror stories of unstable markets. The fear is valid. After all, your shares and investments are at an elevated risk in an unpredictable environment.

    By Kim,

    • 0 comments
    • 193 views
  • Models and their limits

    Options traders tend to think mathematically. When considering selection of an underlying, risks and expected profits, the model of outcomes is a primary tool for making selections. Without a model how can anyone understand the differences between two or more options that might otherwise appear the same – similar moneyness, same strike, and same premium.

    By Michael C. Thomsett,

    • 0 comments
    • 195 views
  • When You've Only Got $1000 To Invest, What Do You Do?

    Are you new to the world of investments? Most likely; it’s not something you just fall into! BUt at the same time, investing can be done by anyone. Investing doesn’t need to be saved for retirement. It isn’t something only the uber rich are able to get into.

    By Kim,

    • 0 comments
    • 436 views
  • Use of Options Spreads to Reduce Risk

    Traders may view spreads as a means for reducing market risk. But this also means that the potential profit is just as limited as potential loss, and this is easily overlooked in the focus on risk alone. A realistic view of spreading is that it reduces risk in exchange for accepting limited maximum profit.

    By Michael C. Thomsett,

    • 0 comments
    • 502 views
  • Put Writing in 2020: The Role of Timing Luck

    The impact of luck can play a meaningful role in the short-term outcomes of monthly option trades due to the requirement to roll expiring contracts. The extreme volatility in 2020 highlightsthis fact when we look at results of SPY cash secured put trades launched on slightly different start dates.

    By Jesse,

    • 0 comments
    • 493 views
  • The problem of Option Math

    Option traders may be divided into two categories. First are those relying on instinct or casual observation. This group tends to speculate on directional movement, future volatility, value, and on potential profitability of trades. The second group is involved deeply with math of trading and depends on what is perceived as certainty or near certainty.

    By Michael C. Thomsett,

    • 0 comments
    • 663 views
  • Put/Call Parity: Two Definitions

    Traders hear the term put/call parity a lot, but what does it mean? There are two definitions and they are vastly different from one another. The first definition involves the net credit/debit for any combination trade, with trading costs are considered. The second definition takes assumed interest rates and present value into mind.

    By Michael C. Thomsett,

    • 0 comments
    • 552 views

  Report Article

We want to hear from you!


There are no comments to display.



Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs Expertido