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The Black-Scholes model and the Cox, Ross and Rubinstein binomial model are the primary pricing
models used by the software available from this site (Finance Add-in for Excel, theOptions Strategy
Evaluation Tool, and the on-line pricing calculators.)

Both models are based on the same theoretical foundations and assumptions (such as the geometric
Brownian motion theory of stock price behaviour and risk-neutral valuation). However, there are also
some some important differences between the two models and these are highlighted below.

  
 

The Black-Scholes model is used to calculate a theoretical call price (ignoring dividends paid during the
life of the option) using the five key determinants of an option's price: stock price, strike price, volatility,
time to expiration, and short-term (risk free) interest rate.

The original formula for calculating the theoretical option price (OP) is as follows:

Where:

The variables are:

S = stock price
X = strike price
t = time remaining until expiration, expressed as a percent of a year
r = current continuously compounded risk-free interest rate
v = annual volatility of stock price (the standard deviation of the short-term returns over one year). See
below for how to estimate volatility.
ln = natural logarithm
N(x) = standard normal cumulative distribution function
e = the exponential function

  


 


The model is based on a normal distribution of underlying asset returns which is the same thing as saying
that the underlying asset prices themselves are lognormally distributed. A lognormal distribution has a
longer right tail compared with a normal, or bell-shaped, distribution. The lognormal distribution allows for
a stock price distribution of between zero and infinity (ie no negative prices) and has an upward bias
(representing the fact that a stock price can only drop 100% but can rise by more than 100%).

In practice underlying asset price distributions often depart significantly from the lognormal. For example
historical distributions of underlying asset returns often have fatter left and right tails than a normal
distribution indicating that dramatic market moves occur with greater frequency than would be predicted
by a normal distribution of returns-- ie more very high returns and more very low returns.

A corollary of this is the volatility smile -- the way in which at-the-money options often have a lower
volatility than deeply out-of- the-money options or deeply in-the- money options.

The Excel add-in which can be downloaded from this site contains three sets of tools for dealing with non-
lognormally distributed asset prices and the volatility smile:

Modified Black-Scholes and binomial pricing (using implied binomial trees) for European and American
option pricing with non-lognormal distributions. These models can be used to see the impact on option
prices of non-lognormal price distributions (as measured by coefficents of skewness (symmetry) and
kurtosis (fatness of distribution tails and height of peaks)), and to calculate and plot the volatility smile
implied by these distributions.

Measuring the degree to which historical asset price distributions diverge from the lognormal (as
measured by coefficents of skewness and kurtosis).

Plotting non-lognormal distribution curves for specified coefficients of skewness and Kurtosis (as well
as volatility etc) to see how they differ from the lognormal.

In addition to using the add-in you can use the on-line stock price distribution calculator to examine the
sensitivity of the shape of the lognormal stock price distribution curve to changes in time, volatility, and
expected growth rates. And you can also use the on-line stock price probability calculator to look at the
probabilities of stock prices exceeding upper and lower boundary prices -- both at the end of a specified
number of days and at any time during the period.

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This is the most critical parameter for option pricing -- option prices are very sensitive to changes in
volatility. Volatility however cannot be directly observed and must be estimated.Y

Whilst implied volatility -- the volatility of the option implied by current market prices -- is commonly used
the argument that this is the "best" estimate is somewhat circular. Skilled options traders will not rely
solely on implied volatility but will look behind the estimates to see whether or not they are higher or
lower than you would expect from historical and current volatilities, and hence whether options are more
expensive or cheaper than perhaps they should be.

It's a slight over simplification, but basically implied volatility will give you the ‘
 of an option; historical
volatility will give you an indication of its . It's important to understand both. For instance, if your
forecast of volatility based on historical prices is greater than current implied volatility (options under
valued) you might want to  a straddle; if your historical forecast is less than implied volatility you might
want to
 a straddle.
This site contains one of the most comprehensive sets of tools available for getting a handle on volatility.
The tools include an Historic Volatility Calculator (which automatically extracts historic prices from the
web, and calculates and graphs volatility), an Implied Volatility Calculator (which retrieves and calculates
implied volatility for an entire option chain), and an Excel Add-in (for those who like to build their own
Excel applications). The volatility functions in the add-in include:

6   
 
 calculation (American and European options, with and without dividends).

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 estimation using historical prices: one or more of high-low,
closing, and open prices. All the price data required are available at no charge at sites such as Yahoo.

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 estimation using the EWMA (exponentially weighted
moving average) model or the GARCH model. These models give greater emphasis to more recent
prices.

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 using the GARCH model, which lets you see how volatility is likely to move in
the future. A common application of this is to create volatility term structures for the weeks or months
ahead to answer questions like "what volatility should I use for pricing an option with a life of three
months?".

The implied volatility, historical volatility, and forecast volatility tools are complementary. With volatility
being such a critical factor a good options trader will use all three sets of tools to help form a view about
the volatility to use in pricing options.

See the Finance Add-in for Excel and Volatility FAQs pages, Historic Volatility Calculator page,Implied
Volatility Calculator page, and the on-line demos for more information.

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Unlike volatility, which is all important for determining the fair value of an option, views about the future
direction of an underlying asset (ie whether you think it will go up or down in the future and by how much)
are ‘  
 .

Significantly, the expected rate of return of the stock (which would incorporate risk preferences of
investors as an equity risk premium) is  one of the variables in the Black-Scholes model (or any other
model for option valuation). The important implication is that the value of an option is completely
independent of the expected growth of the underlying asset (and is therefore risk neutral).

Thus, while any two investors may strongly disagree on the rate of return they expect on a stock they will,
given agreement to the assumptions of volatility and the risk free rate, always agree on the fair value of
the option on that underlying asset.

The fact that a prediction of the future price of the underlying asset is not necessary to value an option
may appear to be counter intuitive, but it can easily be shown to be correct. Dynamically hedging a call
using underlying asset prices generated from Monte Carlo simulation is a particularly convincing way of
demonstrating this. Irrespective of the assumptions regarding stock price growth built into the Monte
Carlo simulation the cost of hedging a call (ie dynamically maintaining a delta neutral position by buying &
selling the underlying asset) will always be the same, and will be very close to the Black-Scholes value.
(The Excel add-in available from this site contains a Monte Carlo simulation component which can be
used for this purpose.)
Putting it another way, whether the stock price rises or falls after, eg, writing a call, it will always cost the
same (providing volatility remains constant) to dynamically hedge the call and this cost, when discounted
back to present value at the risk free rate, is very close to the Black-Scholes value.

Which is hardly surprising given that the Black-Scholes price is nothing more than the amount an option
writer would require as compensation for writing a call and completely hedging the risk. The important
point is that the hedger's view about future stock prices is irrelevant.

This key concept underlying the valuation of all derivatives -- that fact that the price of an option is
independent of the risk preferences of investors -- is called

 
. It means that all
derivatives can be valued by assuming that the return from their underlying assets is the risk free rate.

 
 &



 
 ' The main advantage of the Black-Scholes model is speed -- it lets you calculate a very large
number of option prices in a very short time.



' The Black-Scholes model has one major limitation: it cannot be used to accurately price
options with an American-style exercise as it only calculates the option price at one point in time -- at
expiration. It does not consider the steps along the way where there could be the possibility of early
exercise of an American option.

As all exchange traded equity options have American-style exercise (ie they can be exercised at any
time as opposed to European options which can only be exercised at expiration) this is a significant
limitation.

The exception to this is an American call on a non-dividend paying asset. In this case the call is always
worth the same as its European equivalent as there is never any advantage in exercising early.

Various adjustments are sometimes made to the Black-Scholes price to enable it to approximate
American option prices (eg the Fischer Black Pseudo-American method) but these only work well within
certain limits and they don't really work well for puts.

 
 

The binomial model breaks down the time to expiration into potentially a very large number of time
intervals, or steps. A tree of stock prices is initially produced working forward from the present to
expiration. At each step it is assumed that the stock price will move up or down by an amount calculated
using volatility and time to expiration. This produces a binomial distribution, or recombining tree, of
underlying stock prices. The tree represents all the possible paths that the stock price could take during
the life of the option.

At the end of the tree -- ie at expiration of the option -- all the terminal option prices for each of the final
possible stock prices are known as they simply equal their intrinsic values.

Next the option prices at each step of the tree are calculated working back from expiration to the
present. The option prices at each step are used to derive the option prices at the next step of the tree
using risk neutral valuation based on the probabilities of the stock prices moving up or down, the risk free
rate and the time interval of each step. Any adjustments to stock prices (at an ex-dividend date) or option
prices (as a result of early exercise of American options) are worked into the calculations at the required
point in time. At the top of the tree you are left with one option price.
To get a feel for how the binomial model works you can use the on-line binomial tree calculators: either
using the original Cox, Ross, & Rubinstein tree or the equal probabilities tree, which produces equally
accurate results while overcoming some of the limitations of the C-R-R model. The calculators let you
calculate European or American option prices and display graphically the tree structure used in the
calculation. Dividends can be specified as being discrete or as an annual yield, and points at which early
exercise is assumed for American options are highlighted.

 
 &



 
 ' The big advantage the binomial model has over the Black-Scholes model is that it can be
used to accurately price American options. This is because with the binomial model it's possible to check
at every point in an option's life (ie at every step of the binomial tree) for the possibility of early
exercise (eg where, due to eg a dividend, or a put being deeply in the money the option price at that point
is less than its intrinsic value).

Where an early exercise point is found it is assumed that the option holder would elect to exercise, and
the option price can be adjusted to equal the intrinsic value at that point. This then flows into the
calculations higher up the tree and so on.

The on-line binomial tree graphical option calculator highlights those points in the tree structure where
early exercise would have have caused an American price to differ from a European price.

The binomial model basically solves the same equation, using a computational procedure that the Black-
Scholes model solves using an analytic approach and in doing so provides opportunities along the way to
check for early exercise for American options.



' The main limitation of the binomial model is its relatively slow speed. It's great for half a
dozen calculations at a time but even with today's fastest PCs it's not a practical solution for the
calculation of thousands of prices in a few seconds.

% 
 

  

The same underlying assumptions regarding stock prices underpin both the binomial and Black-Scholes
models: that stock prices follow a stochastic process described by geometric brownian motion. As a
result, for European options, the binomial model converges on the Black-Scholes formula as the number
of binomial calculation steps increases. In fact the Black-Scholes model for European options is really a
special case of the binomial model where the number of binomial steps is infinite. In other words, the
binomial model provides discrete approximations to the continuous process underlying the Black-Scholes
model.

Whilst the Cox, Ross & Rubinstein binomial model and the Black-Scholes model ultimately converge as
the number of time steps gets infinitely large and the length of each step gets infinitesimally small this
convergence, except for at-the-money options, is anything but smooth or uniform. To examine the way in
which the two models converge see the on-line Black-Scholes/Binomial convergence analysis calculator.
This lets you examine graphically how convergence changes as the number of steps in the binomial
calculation increases as well as the impact on convergence of changes to the strike price, stock price,
time to expiration, volatility and risk free interest rate.

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For rapid calculation of a large number of prices, analytic models, like Black-Scholes, are the only
practical option on even the fastest PCs. However, the pricing of American options (other than calls on
non-dividend paying assets) using analytic models is more difficult than for European options.

To handle American option pricing in an efficient manner other models have been developed. Three of
the most widely used models which are used where appropriate in the the software available from this
site include:

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' The RGW formula can be used for pricing an American
call on a stock paying discrete dividends. Because it is an analytic solution it is relatively fast.

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$ ' Although the RGW formula is an analytic solution it
involves solving equations iteratively and thus it is slower than Black-Scholes. Black's approximation
basically involves using the Black-Scholes model after making adjustments to the stock price and
expiration date to take account of early exercise.

) "
 #
' An analytic solution for American puts and
calls paying a continuous dividend. Like the RGW formula it involves solving equations iteratively so
whilst it is much faster than the binomial model it is still much slower than Black-Scholes.

+


A by-product of the Black-Scholes model is the calculation of the delta: the degree to which an option
price will move given a small change in the underlying stock price. For example, an option with a delta of
0.5 will move half a cent for every full cent movement in the underlying stock.

A deeply out-of-the-money call will have a delta very close to zero; a deeply in-the-money call will have a
delta very close to 1.

The formula for a the delta of a European call on a non-dividend paying stock is:

Delta = ã
 (see Black-Scholes formula above for d1)

Call deltas are positive; put deltas are negative, reflecting the fact that the put option price and the
underlying stock price are inversely related. The put delta equals the call delta - 1.Y

The delta is often called the Ô
 
: If you have a portfolio short n options (eg you have written n
calls) then n multiplied by the delta gives you the number of shares (ie units of the underlying) you would
need to create a riskless position - ie a portfolio which would be worth the same whether the stock price
rose by a very small amount or fell by a very small amount. In such a "delta neutral" portfolio any gain in
the value of the shares held due to a rise in the share price would be exactly offset by a loss on the value
of the calls written, and vice versa.Y

Note that as the delta changes with the stock price and time to expiration the number of shares would
need to be continually adjusted to maintain the hedge. How quickly the delta changes with the stock price
is given by gamma (see "Greeks" below).

The Options Strategy Evaluation Tool, which can be downloaded from this site, calculates and displays
the delta for each individual option trade entered into the tool. If you set up a covered call in the Options
Strategy Evaluation Tool using Black-Scholes European pricing (ie sell n calls and buy n underlying
shares) then change the number of shares bought to be equal to the number of options multiplied by the
delta you will have an example of a hedged position. Notice how the time line (ie the curved line showing
the profit at the number of days to expiration) on the payoff diagram just touches (but doesn't pass
through) the horizontal axis at one point only: the point equal to the current share price. Moving a short
distance in either direction on this line will have the same impact on profit. ie you are delta hedged.

The Options Strategy Evaluation Tool also calculates the ‘


  for a range of stock prices and
days to expiration -- that is, the delta of the entire strategy consisting of multiple option trades and trades
in the underlying stock. The position delta, sometimes called the Equivalent Stock Position (ESP) lets you
see, for example, how a dollar rise in the underlying stock prices will affect the overall profitability of the
entire strategy. For example, if the ESP of a portfolio, or strategy, is -2,300 it means that the market
exposure of the portfolio is equivalent to a portfolio short 2,300 shares. Thus a one dollar rise in the stock
price will cause the profitability of the entire position to fall by $2,300.

The other position "Greeks" are also calculated by the model as well -- see below.

You can also see how the delta changes with stock price, volatility, time to expiration and interest rate by
using the on-line options calculator.




In addition to delta there are some other "Greeks" which some find useful when constructing option
strategies:

' It measures how fast the
  changes for small changes in the underlying stock price. ie
the delta of the delta.

If you are hedging a portfolio using the delta-hedge technique described under "Delta", then you will
want to keep gamma as small as possible as the smaller it is the less often you will have to adjust the
hedge to maintain a delta neutral position. If gamma is too large a small change in stock price could
wreck your hedge. Adjusting gamma, however, can be tricky and is generally done using options --
unlike delta, it can't be done by buying or selling the underlying asset as the gamma of the underlying
asset is, by definition, always zero so more or less of it won't affect the gamma of the total portfolio.

w ' The change in option price given a one percentage point change in volatility. Like delta and
gamma, vega is also used for hedging.


' The change in option price given a one day decrease in time to expiration. Basically a measure
of time decay. Unless you and your portfolio are travelling at close to the speed of light the passage of
time is constant and inexorable. Thus hedging a portfolio against time decay, the effects of which are
completely predictable, would be pointless.

%' The change in option price given a one percentage point change in the risk-free interest rate.

The on-line Black-Scholes calculator calculates these derived measures for each set of variables
submitted for calculation. Like delta, these "Greeks" vary with changes in each of the underlying Black-
Scholes variables. eg the gamma varies as the volatility changes. You can see graphically how each
derived measure changes as the underlying Black-Scholes variables change.

The Options Strategy Evaluation Tool calculates the position "Greeks" -- ie the "Greeks" for individual
option and stock trades and for the entire strategy or portfolio (ie net position "Greeks"). This lets you see
how the profitability of the strategy is impacted by changes to stock price, time to expiration, volatility etc. Y

All the "Greeks" can be viewed graphically thereby highlighting how they change with changes in the
underlying asset and with time.
The Options Strategy Evaluation Tool contains an automatic position hedging feature that lets you
achieve target neutrality outcomes with respect to delta, delta and gamma, vega, delta and vega, or
delta, gamma, and vega.

Finally the Excel add-in available from this site contains a position hedging function that not only lets you
achieve neutrality in key combinations of the "Greeks" but also lets you specify specific positive or
negative targets for individual "Greeks" and combinations of the "Greeks".