So it seems like what I observed initially. All the greeks and the BSM stuff are general guidelines. general rules that all traders and MM should understand. However, the pricing itself is really up to the MM and things will sell for what the market can bear. It looks like our role as traders is to ID what we feel to be well priced.
black scholes model pricing vs real life pricing
- Thread starter Abundance Magnet
- Start date
Well actually... as a trader you make a judgement that something isn't priced correctly, then taking the position which assumes a profit when it will be back in line with your thoughts/analysis.
It then depends on whether you know more than the market or market makers involved. I would argue that usually they have better knowledge than a retail trader... therefore the market is correct.
That's an Efficient Market Hypothesis viewpoint... and I know for a fact that markets aren't as efficiently priced.... but initially my standpoint is that the market is correctly priced.
Fair value is what you think the option is worth. (ie where your expected pnl=0).
Everyone has a different fair value for an option based on their view, their platform, and the accuracy of their models; however, in reality most people are pretty close.
Your job is to find someone who has a different fairvalue than you and trade with them.
I'd expand that to say that when you have a difference of opinion on the fair value of an option, that difference is typically a difference in views on it's volatility, not absolute price. The price is simply a mechanical end result of the volatility. This is why BS has value because allows everyone in the market to come to the same IV value, which is what matters. This can be a little mind bending when you're first learning options when your natural tendency is to evaluate them like a stock based on price.
on a similar note... is there a way to calculate (understanding that different MM and ppl use different formulas) the rough IV value of an option? that is to separate the intrinsic value vs extrinsic; and separating the extrinsic to time value and IV.
likewise, which formulas to use for short term options, and which for long term options? Interesting comment earlier about how BSM is best for short term options. I didn't know that....
likewise, which formulas to use for short term options, and which for long term options? Interesting comment earlier about how BSM is best for short term options. I didn't know that....
I apologize for the laziness of not responding more directly earlier, but that statement is 180°, 100%, wrong.
so this is where misinformation starts...
so how does the pricing formula for short term options differ from mid term to long term. i.e. weekly vs monthly vs LEAPS...
thanks!
It's not that it differs per se, but that BSM (et al.!) models were constructed to represent derivatives over their greater lifetimes -- within that last few days, they don't do nearly as well as what supplanted them: the binomial model. And in turn, binomial models do not do so well as the time horizon grows.
Galileo made marvelous statements about gravity by dropping dissimilar-sized rocks off of the Leaning Tower of Pisa, and having them land at the same time. But, what would have happened if he'd dropped 5lbs of sand, too? Or dumped a 5lb bucket of goose down?
The model has to fit the circumstances.