The BlackScholes option
valuation model, developed by Fisher Black and Myron Scholes in
1973 is without doubt the most popular option analysis and
pricing model in use today, attempting as it does to predict fair
option prices using rigorous mathematical models based on a security's
price and volatility, time until expiration, and the current market
interest rate. The Put/Call price is the main output of the BlackScholes
model, helping to answer the question of whether the option is overpriced
or underpriced. Unfortunately the main use of this (to find and
exploit over or underpriced options) is now less useful than it
was, as everyone has access to the same equation, and barring machine
failure, will generally price their options correctly. Long Term
Capital management (yes, THAT turkey) used the model to try and
create a "riskless" hedge to earn arbitrage profits (e.g. by buying
underpriced calls and then shorting the underlying stock, having
only to wait for the option to return to its fair market value resulting
in arbitrage profits). The success (or otherwise!) of LTCM is well
documented, but the model itself is still generally regarded as
valid, it was the application of it that was at fault.
An associated term is Delta (the relative amount an option's price
will change if the underlying security's price changes, hardly ever
1 for 1). Deep inthemoney options tend to have high Deltas, because
almost all of the gain/loss in the security will be reflected in
the option price. Deep outofthemoney options tend to have a low
Delta, because they are already dogs, and how bad can it get? As
expiration approaches, Delta 'firms up' one way or the other  the
Delta of inthemoney options approaches 1 because there is simply
less time for them to soften into 'outofthemoney' options.
A further associated term is Gamma, which indicates the risk involved
with an option. Large Gammas suggest higher risk, because the value
of the option is likely to change fast (it is geared). Other options
terms, and the calculation of the BlackScholes equations are outside
the scope of this article.
Day traders often try to create a 'riskless' position, but transaction
costs and time decay on these options (and the unwillingness of
the market to behave) usually conspire to thwart them..
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