Well ya.. I just think there is a threshold in time in which risks change .. Like when vol risk turns mostly to gamma risk .. Because the mean reverting nature of vol and the ever increasing influence of interest rates leaps become cheaper because they closer repsent the long term average of vol and they are cheaper becuadr of this lower interest rate environment.... So a long term trend bet works better.. Cheaper leverage with less everyday volatility influence
The models are not perfect because they're not clairvoyant. They are simply the best approximation available. If you're trying to price a derivative for a specific need, then a model is helpful. Trading in public equity markets, as I assume you're proposing, not so much. But I'm a fan of learning as much as you can about any endeavor, so you should understand the basis for the models, but don't expect them to materially influence your success. Overpriced vol does not necessarily make for a positive p/l, but it's a step in the right direction-if you are looking to short gamma. But I think you're missing the reality that market participants don't all have the same expectations. Some are path-dependent, and thus can't tolerate a loss that exceeds some predetermined threshold. Some have a view on the future price of the underlying and want to use options to express that view. And others have long equity portfolios that require participation in the derivative markets for marketing or compliance reasons. So, for many traders, vol is not an unimportant part of the equation, but it may not be as relevant to them as it might be to you. Depends. I'd re-read that section and verify your interpretation. For instance, you may be thinking short and the author may be describing long. Sometimes they are priced higher, if market participants bid them so. But put-call parity has nothing to do with the explanation. And in a liquid offering, there's nothing to be exploited. Models have flaws, but the market pricing is whatever the market pricing is. It's not an issue of being flawed. Except in hindsight. I was commenting in general about several concepts you were addressing: models, markets, overpriced, underpriced, moneyness, etc. No biggie.
Black Scholes is a MODEL (let that word sink in for a minute..) based on several assumptions that do not exist in the real world. That should answer all of these questions .
Thanks for giving us such powerful, new information. Yes, Black-Scholes is a MODEL (who knew?). Yes, empirical evidence shows it's assumptions are violated. But if it's such a piece of junk, why has it stood the test of time? Why is it still being used today by plenty of very smart people around the world?
...Kind of off-topic, But I recently watched a documentary on Youtube about the Black-Scholes model and Long-Term Capital Management: The Midas Formula: Trillion Dollar Bet (2000)
rmorse- I believe this model is popular for American equity options, particularly for addressing dividend issues. I'm not saying there aren't other models out there, many of which are also used heavily in practice. My point was that discounting Black-Scholes as completely worthless is a silly blanket statement to make. It can be used effectively, despite the usual LTCM references.
A more realistic model is to combine Merton-style lognormally distributed jump process to the Heston stochastic volatility process. But this discussion would probably be better suited to the Wilmott forums.