I've noticed that ppl regard (or used to) the BSM model quite highly. However, the real life pricing can be quite a bit different. MM's playing games with pricing (baiting, etc..). I've seen bids and asks on different strike prices which didn't seem to make much sense. Especially with wide B-A prices and not knowing where things will get filled, what is the role of BSM? How do you gauge what is fair value for your option? the obvious answer is 'whatever the market can bear', but how do you know if the current value is above or below 'fair value'?
Until the last 48-60 hours, BSM works quite well at presenting "fair" MID prices. (FWIW, the various Binomial models were answers to BSM short-time problems.) (FWIW, my recollection is that the original JPE articles used a 365 day throughout -- I have found 252 to be an improvement. As well, even a recent survey (like, during the 2018 calendar year) shows disinterested-but-balanced use of both... ) If the BID or ASK are far away in a thin market? Don't blame BSM.
There's a great book called Volatility Trading, by Euan Sinclair which might point you in the right direction. Don't worry about trying to directly value the option, just compare the implied volatility of the option with your volatility forecast for the underlying. If there is a large enough difference, then you can make money with a delta-hedged position. Of course, this is easier said than done...
cool. that's on my list to read. I'll check it out. I recently read 'Time is Money' by Kerry Given. Pretty good book. I've noticed there are three types of books: 1) the 'academics' books - books by academics that aren't traders and therefore lack the traders perspective or reality. 2) the 'public knowledge/myth' books - regurgitating old, dated information and 3) and then there are the 'traders books'. Books by true traders that have been successful at their craft. Those are the good books to read. IDing them... harder to do until they've been read. any suggestions for traders books?
Black & Scholes model is only a pricing MODEL. It only provides a theory of how options should be priced. It does NOT take into account of real life market situation such as supply & demand, liquidity and etc.
It does do a good job of providing a standard implied volatility though. Something that's always useful if you're an options trader.
Yes that is true but the price you see would not necessarily be the price that you are going to get when you are actually trading in the market.
What price would you see? Based on what IV? You need to understand that midpoint does not necessarily mean the point where everything gets traded. You could argue that the midpoint is a market makers theoretical fair value... but for them to take a trade, it should give them an incentive to trade it. So x.xx below fair value... otherwise, how would they make money? The more liquid certain options series are, the tighter the spreads and the more likely it will be that you get traded at around the midpoint. But you can always assess the price you trade, via say the BS-model, to give you the IV you've just traded. IMO, the only time BS really screws up is when there are things like (multiple) dividends involved. But it depends on what you use it for...