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Black-Scholes Model
The Smart Profits Report: Issue #149
Friday, October 08, 2004
Black-Scholes Model: Finding Fair Value And 30% Returns in Two Days
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
You’ve probably heard of the Black-Scholes Model for options pricing. It is the guide by which all options - including those issued by companies to employees - are priced.
Of course, just because there is a model out there for pricing an option, it does not mean that the option price you see on any of the exchanges is accurate.
No, no, no - that would be too easy and too clean.
Remember, the options market makers don’t want you to make money; they want it all for themselves. That is the primary reason to make sure that you understand all there is to understand about options - including when you’re getting good value or not.
There are many websites that offer you tips on options, but there aren’t many that offer you an easy-to-use calculator that allows you to determine the fair price of an option completely independent of the market makers. Here is one that I like.
Using the Black-Scholes Model
In order to use this website, you need to have several pieces of information:
- The price of the underlying stock: The basic stock price.
- Days to expiration on the option you’re considering: Just enter the number of days that the option is valid for.
- Strike price on the option
- The risk-free rate of return: The risk-free rate of return is the interest rate paid by the government or a bank on guaranteed investments like CDs or Treasury notes. For now, use 3% or 4% as an approximation.
- The volatility factor of the stock…
The volatility factor of the stock can be found on numerous websites and quote services.
For example, MyTrack (http://www.mytrack.com), the service that I use, lists volatility for each stock. You can also find volatility numbers on the Chicago Board of Options Exchange (CBOE) website.
Just follow the link marked “volatility” and enter the symbol.
Arm Yourself With the Real Value - And Beat the Market Makers
Once you have these pieces of information, you can use the website above to do what so many novice options investors can’t: get a fair market value for the options you’re considering.
Why is that so important?
Finding the real “value” of an option is critical because it allows you to outdo the market makers.
For example, I recently recommended IACI call options in my LEAPS options service. The option I chose has more than 2.4 years left on it. Based on the calculations I made using the Black-Scholes options pricing model, I found that the options were trading at a discount of more than 30% to their fair value.
It wasn’t the reason we bought the option, but it was a great confirming indicator.
Locking In 30% Profits… With Two Years of Upside Ahead
And lo and behold, a couple of days after we bought, the share price moved up 5% and our option moved up 30%. We did not sell - not with more than two years remaining on our option - but it showed me that the market was under-pricing our option.
Remember, when buying or selling an option, you are investing in a “wasting” asset. Time is always a critical factor because options expire.
So, it is in our best interest to make sure that any options investment we make is actually worth at least what we are paying for it… or, as in the case of IACI, significantly more.
Good trading,
Karim Rahemtulla
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Today’s Smart Profits Cribsheet
- Check out the Smart Profits Glossary for definitions of options terminology used above such as, “Black-Scholes Model” and “volatility.”
Related Articles:
- What Market Makers Really Do
- Are Market Makers Playing Games With Our Profits?
- Understanding Options Risk: How to Beat the “Volatility Premium” on Options
