The Black Scholes model is the term that is used in the context of the options market it refers to a formula that is used to calculate the fair price or theoretical value for a call or put option. It was created by Fischer Black and Myron Scholes in 1973, and since then has it revolutionized the options market. The Black Scholes model is used by the traders as well as the investors to determine whether an option is overvalued or undervalued so that they can trade the options and benefit from any price difference which is always present due to the irrational nature of the stock markets. In order to have a better understanding of this concept, one should look at some of the advantages and disadvantages of the black scholes model –
Advantages of Black Scholes Model
Accuracy
The first and foremost advantage of black scholes model is that it is one of the most accurate option pricing models which is available as compared to other option pricing models. It takes into account all of the factors that can affect the price of an option, including time to expiration, volatility, interest rates, and other important variables which in turn leads to better or accurate pricing of options contracts and thus gives this model an edge over others when it comes to pricing of options.
Speed
Another benefit of the black scholes model is that it can price the options contracts very quickly as it uses a mathematical formula to calculate the price of an option. This makes it a popular choice for traders as in the case of stock markets the prices changes in seconds and traders need to make quick decisions about whether or not to buy or sell an option contract based on the price of underlying which are stocks or index in case of stock markets.
Flexibility of Black Scholes Model
Another important advantage of the black scholes model is that its use is not limited to the stock market only rather it is flexible enough to be used in a variety of different situations. Hence one can use this model to price options not only on stocks but also bonds, commodities, and other assets which makes it a potent tool for traders who want to trade in a variety of assets rather than trading in only one market or asset class.
Black Scholes Model Disadvantages
Ignores Other Factors
The biggest disadvantage of the black scholes model is that while calculating the theoretical value of the option contract it only takes into account the price of the underlying asset and ignores the other important factors. Hence for example it does not take into account other factors like dividends, interest rates, changes in volatility, external shocks, market regulator actions, and so on. This in turn can lead to some inaccuracies in the pricing of options contracts thus defeating the whole idea of using this model for fair pricing of options contracts.
Assumptions of Black Scholes Model
Another limitation of black scholes model is that it is based on many assumptions like the stock price follows a log-normal distribution, the stock market is efficient, there are no arbitrage opportunities, interest rates are constant and so on which we all know are not true which in turn can result in demining the applicability of black scholes model with regards pricing of options contracts.
Problem with American Style Options Contracts
Another problem with the black scholes model is that while calculating American style options contracts it calculates the option price at expiration but in the case of early exercise of American style options there will be a mismatch between the pricing of options thus limiting the use of this model as the majority of exchange traded options are American style options and not European style options.
As one can see from the above that the black scholes model has pros as well as cons and that is the reason why any individual thinking of trading options based on this model should carefully read the above points and then only should take any decision regarding trading options on the basis of black scholes model.