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

  • A Global Equity Put Write Portfolio

    Many that sell equity market put options focus on the S&P 500 (SPX, XSP, SPY). Some will add small caps by selling puts on the Russell 2000 (RUT, IWM). An investor could also make their put selling strategy globally diversified by adding MSCI EAFE (EFA) and Emerging Markets (EEM).

    By Jesse,

    • 0 comments
    • 200 views
  • The Random Walk Hypothesis

    The “random walk hypothesis” (RWH) is one idea about how stock prices behave – but only one of many. It is a theory promoted in academia and believed in my many, but not so much by traders involved with handling real money. Theories aside, is the market truly random?

    By Michael C. Thomsett,

    • 0 comments
    • 279 views
  • How To Trade Options Successfully

    I’ve now been trading options for over a decade and been associated with Steady Options for seven years – hard to believe.  Over that period, I’ve learned quite a bit about option trading; how to improve, what not to do, and generally how the option markets work. I’m still learning.

    By cwelsh,

    • 3 comments
    • 528 views
  • January 2019 Performance Analysis

    No one likes losing money, and no one likes hearing "excuses". However, in an effort to be fully transparent, solicit feedback, and to improve our own performance, we're writing this article to do a further breakdown of the losses which our model portfolio incurred in January 2019. 

    By Kim,

    • 17 comments
    • 1,322 views
  • Island Clusters as Strong Reversals

    Options traders constantly seek the elusive reliable reversal signal. A few unusual but strong reversals are worth looking for, and their patterns reveal likely exceptional timing for opening or closing option trades. One example of this exceptionally strong signal is the island cluster (or, island reversal).

    By Michael C. Thomsett,

    • 0 comments
    • 357 views
  • What’s Wrong With Your 401(k)? (If anything)

    There currently are over sixty million Americans that are active 401(k) participants, and well over 500,000 total active 401(k) plans offered by employers in the United States.  Despite these high numbers, usages could be higher, as the US Census Bureau estimates that only 41% of all employees with access to a 401(k) plan utilize it, with even less funding it fully.

    By cwelsh,

    • 0 comments
    • 439 views
  • Upcoming Decay of Options

    I am on the hunt for a short volatility position for three main reasons. First, the market’s wild swings have, for the time being at least, diminished. Second, option activity has dried up as my options barometer continues to be stuck in the 4 – 6 range as traders are not making big bets in either direction.

    By Jacob Mintz,

    • 0 comments
    • 521 views
  • The Scientific Process of Increasing Expected Returns

    For many US investors, the "base case" for equity investing is US large cap stocks, most commonly benchmarked as the S&P 500. You could absolutely do far worse than owning these 500 great US companies, and the weight of the evidence suggests that most actively managed mutual funds that benchmark themselves against the S&P 500 index have in fact done worse.

    By Jesse,

    • 0 comments
    • 908 views
  • Those Golden and Death Crosses

    The use of moving average (MA) for predicting future price behavior must be undertaken cautiously. MA is a lagging indicator, so the question must be: Can a lagging indicator provide guidance for the future? Yes. The use of two MA lines and how they interact is a reliable form of reversal indicator.

    By Michael C. Thomsett,

    • 0 comments
    • 633 views
  • Trading Reverse Iron Condors When IV Is Elevated

    Our members know that pre earnings straddles and calendars have been our bread and butter strategies in the recent years. We enter those trades when the prices are cheap compared to previous cycles. However, in the last few months of 2018, Implied Volatility exploded, making most of those trades too expensive.

    By Kim,

    • 0 comments
    • 706 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