Options Pricing: BlackScholes Model
The BlackScholes model for calculating the premium of an option was introduced in 1973 in a paper entitled, "The Pricing of Options and Corporate Liabilities" published in the Journal of Political Economy. The formula, developed by three economists – Fischer Black, Myron Scholes and Robert Merton – is perhaps the world's most wellknown options pricing model. Black passed away two years before Scholes and Merton were awarded the 1997 Nobel Prize in Economics for their work in finding a new method to determine the value of derivatives (the Nobel Prize is not given posthumously; however, the Nobel committee acknowledged Black's role in the BlackScholes model).
The BlackScholes model is used to calculate the theoretical price of European put and call options, ignoring any dividends paid during the option's lifetime. While the original BlackScholes model did not take into consideration the effects of dividends paid during the life of the option, the model can be adapted to account for dividends by determining the exdividend date value of the underlying stock.
The model makes certain assumptions, including:
 The options are European and can only be exercised at expiration
 No dividends are paid out during the life of the option
 Efficient markets (i.e., market movements cannot be predicted)
 No commissions
 The riskfree rate and volatility of the underlying are known and constant
 Follows a lognormal distribution; that is, returns on the underlying are normally distributed.
The formula, shown in Figure 4, takes the following variables into consideration:
 Current underlying price
 Options strike price
 Time until expiration, expressed as a percent of a year
 Implied volatility
 Riskfree interest rates
Figure 4: The BlackScholes pricing formula for call options. 
The model is essentially divided into two parts: the first part, SN(d1), multiplies the price by the change in the call premium in relation to a change in the underlying price. This part of the formula shows the expected benefit of purchasing the underlying outright. The second part, N(d2)Ke^(rt), provides the current value of paying the exercise price upon expiration (remember, the BlackScholes model applies to European options that are exercisable only on expiration day). The value of the option is calculated by taking the difference between the two parts, as shown in the equation.
The mathematics involved in the formula is complicated and can be intimidating. Fortunately, however, traders and investors do not need to know or even understand the math to apply BlackScholes modeling in their own strategies. As mentioned previously, options traders have access to a variety of online options calculators and many of today's trading platforms boast robust options analysis tools, including indicators and spreadsheets that perform the calculations and output the options pricing values. An example of an online BlackScholes calculator is shown in Figure 5; the user must input all five variables (strike price, stock price, time (days), volatility and risk free interest rate).
Figure 5: An online BlackScholes calculator can be used to get values for both calls and puts. Users must enter the required fields and the calculator does the rest. Calculator courtesy www.tradingtoday.com 

Derivative
A security with a price that is dependent upon or derived from ... 
Security
A financial instrument that represents an ownership position ... 
Series 6
A securities license entitling the holder to register as a limited ... 
Internal Rate Of Return  IRR
A metric used in capital budgeting measuring the profitability ... 
Board Of Directors  B Of D
A group of individuals that are elected as, or elected to act ... 
Strike Width
The difference between the strike price of an option and the ...

How is the price of a derivative determined?
Many different types of derivatives have different pricing mechanisms. The most common derivative types are futures contracts, ... Read Full Answer >> 
What is a stock split? Why do stocks split?
All publiclytraded companies have a set number of shares that are outstanding on the stock market. A stock split is a decision ... Read Full Answer >> 
Is there a difference between financial spread betting and arbitrage?
Financial spread betting is a type of speculation that involves a highly leveraged derivative product, whereas arbitrage ... Read Full Answer >> 
How do I place an order to buy or sell shares?
It is easy to get started buying and selling stocks, especially with the advancements in online trading since the turn of ... Read Full Answer >> 
What does a high turnover ratio signify for an investment fund?
If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a oneyear period. ... Read Full Answer >> 
How does a forward contract differ from a call option?
Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>