Quant Quickie: The Black-Scholes Model — Finance’s Time Machine
Ever wondered how Wall Street prices options with such precision?
Introducing the Black-Scholes Model, developed in the 1970s by Fischer Black, Myron Scholes, and Robert Merton. Think of it as a time machine for options pricing - it peers into an uncertain future and estimates what an option is worth today.
At its core, it calculates a fair price for call and put options using five inputs:
S – Current stock price
K – Strike price
T – Time to expiration
r – Risk-free interest rate
σ – Volatility
The model's secret sauce lies in two variables: d₁ and d₂, which represent probabilities that the option will end up profitable (in-the-money), adjusted for time and uncertainty.
Higher volatility = more potential outcomes = more expensive options.
So next time you see a call option priced at £8.02, remember - behind that number is a mathematical model balancing risk, time, and volatility. It’s not a guess, it’s maths making sense of market chaos.
Why it matters: Whether you're trading or just curious, understanding Black-Scholes gives you insight into how modern markets quantify risk and opportunity.
Read the full article here on Medium.