This is the story of Black Scholes formula. Black Scholes formula was invented by 3 young mathematicians some 25 years ago who wanted to solve the problem of market randomness. The inventors of this formula were awarded the Nobel Prize for Economics. This mathematical formula made many people rich. But did it work always? You need to watch this video on Black Scholes formula especially if you are an options trader.
After watching the above video, did you observe one thing? The whole formula is based on one assumption. Everything is normally distributed. This assumption does not work in reality. Stock returns are not normally distributed. The log normal distribution also doesn’t work most of the time. Stock returns are in fact long tailed. What does this tell you? The Black Scholes Options Pricing Model doesn’t work in reality. It is just a theoretical formula that is not used in practical trading. This is another video that explains this options pricing formula in simple terms!
But this doesn’t diminish the importance of this formula. This formula needs modifications. Once those modifications are applied this formula can be used in practice. The most important thing that you need to know in this formula is the volatility. A lot of formulas have been developed to calculate the implied volatility that is required in this formula to calculate the option price. This formula only calculates price of European Style Call Option. You can also watch this much detailed lecture video on how to drive this Black Scholes Options Pricing Model.
Now these were some good videos that we found on this formula. After watching the above videos you should have a fairly good idea how to price stock options. Today options trading is very popular. If you are an options trader, you should watch the above videos and understand how to calculate the price of an option. This will help you avoid buying expensive options contract. Options trading is not an easy thing. Just keep this in your mind. Did you watch the movie on a rogue trader who brought down a bank? Now as said above you need to modify the above formula to make it work in practice. Understanding those modifications will require you to learn stochastic calculus. Did you take a look at our course on Machine Learning Using R For Traders? In this course we take you step by step and show you how you can use machine learning algorithms in your daily trading.