Circumventing the Limitations of Black-Scholes

Mathematical or quantitative model-based trading continues to gain momentum, despite major failures like the financial crisis of 2008-2009, which was attributed to the flawed use of trading models.

Complex trading instruments such as derivatives continue to gain popularity, as do the underlying mathematical models of valuation. While no model is perfect, being aware of its limitations can help in making informed trading decisions, rejecting outlier cases, and avoiding costly mistakes that may result in huge losses.

Limitations of the Black-Scholes Model

There are limitations on the Black-Scholes model, which is one of the most popular models for options pricing. Some of the standard limitations of the Black-Scholes model are:

  • Assumes constant values for the risk-free rate of return and volatility over the option duration. None of those will necessarily remain constant in the real world.
  • Assumes continuous and costless trading—ignoring the impact of liquidity risk and brokerage charges.
  • Assumes stock prices to follow a lognormal pattern, e.g., a random walk (or geometric Brownian motion pattern), thus ignoring large price swings that are observed more frequently in the real world.
  • Assumes no dividend payout—ignoring its impact on the change in valuations.
  • Assumes no early exercise (e.g., fits only European options). That makes the model unsuitable for American options.
  • Other assumptions, which are operational issues, include assuming no penalty or margin requirements for short sales, no arbitrage opportunities, and no taxes. In reality, all these do not hold true. Either additional capital is needed or realistic profit potential is decreased. 

Assume Constants That Aren't

The model assumes certain components of its calculations will be constant. Unfortunately, these factors, volatility and the risk-free rate of return actually change all the time.

Constant Change Means Constant Vigilance

The many underlying assumptions in a Black-Scholes calculation are treated as unchanging in the analysis. In addition to risk-free rate of return and volatility, the underlying stock price and the premium are also subject to frequent change. The only way to mitigate this risk is to keep a close eye on any outstanding option contracts.

Implications of Black-Scholes Limitations

This section describes how the above-mentioned limitations impact day-to-day options trading and whether any prevention or remedial actions can be implemented. Among other problems, the biggest limitation of the Black-Scholes model is that while it provides a calculated price of an option, it remains dependent on the underlying factors that are

  • Assumed to be known
  • Assumed to remain constant during the life of the option

Unfortunately, neither one of the above is true in the real world. Unchanging underlying stock prices, volatility, risk-free rates (the theoretical interest rate of an investment with no risk), and dividends are unknown. Any or all of these may, in fact, change in a short period with high variance.

This changeability leads to equally high fluctuations in option prices. It does, on the other hand, also provide significant profit opportunities to experienced options traders (or ones with luck on their side).

But it comes at a cost to the counterparties—especially those newbies, speculators, or punters on the other side of your option, who are often unaware of the limitations and are at the receiving end.

Black-Scholes Isn't Perfect

The Black-Scholes Model doesn't work on every investment in every circumstance. No investment model is a set-it-and-forget-it device. You have to keep an eye on all the underlying factors.

Avoiding Disaster

It doesn't have to be high-magnitude changes; the frequency of even the minor changes can also lead to problems. In either case, large price changes are more frequently observed in the real world than those that are expected and implied by the Black-Scholes model.

This higher volatility in the underlying stock price results in substantial swings in option valuations. It often leads to disastrous results, especially for short option sellers who may end up being forced to close out positions at huge losses for lack of margin money to hold them or having their American-style options exercised by the buyer.

To prevent any high losses, options traders should keep a constant watch on changing volatility and remain prepared with pre-determined price at which the position will automatically be closed out or stop-loss level.

Model-based valuation should, in other words, be accompanied by realistic and pre-determined stop-loss levels. Intermittent remedial alternatives also include being prepared for price averaging techniques (dollar-cost and value), depending on the situation and strategies.

The Real-World View

Stock prices never show lognormal or normal returns, asis assumed by Black-Scholes. Real-world distributions are skewed. This discrepancy can lead to the Black-Scholes model substantially underpricing or overpricing an option.

Traders unfamiliar with such implications may end up buying overpriced or shorting underpriced options, thereby exposing themselves to significant loss if they blindly follow the Black-Scholes model. As a preventive measure, traders should keep an eye on volatility changes and market developments—attempting to buy when volatility is in the lower range (for instance, as observed over the past duration of the intended option holding period) and sell when it is in the high range to get maximum option premium. 

Coping with Volatility

An additional implication of geometric Brownian motion is that volatility should remain constant during option duration. It also implies that intrinsic value or the moneyness of options should not impact implied volatility, for example, that in-the=money (ITM), at-the-money (ATM), and out-of-the-money (OTM) options should display similar volatility behavior. But in reality, the volatility skew curve is observed (instead of the volatility smile curve) where higher implied volatility is seen for lower strike prices.

Black-Scholes overprices ATM options and underprices deep ITM and deep OTM options. That is why most trading (and hence the highest open interest) is observed for ATM options, rather than for ITM and OTM.

Short sellers get maximum time decay value for ATM options (leading to the highest option premium), compared with premiums for any ITM and OTM options they attempt to capitalize on.

Traders should be cautious and avoid buying OTM and ITM options with high time decay values (option premium = intrinsic value + time decay value). Similarly, educated traders sell ATM options to get higher premiums when volatility is high. Buyers should consider instead purchasing options when volatility is low, leading to paying low premiums. 

Black-Scholes Doesn't Catch Everything

The Black-Scholes Model missed the 2008-2009 crash is believed by many to have actually caused the 1987 Crash.

Extreme Events

In a nutshell, price movements should be assumed with absolute applicability and there is no relation or dependency from other market developments or segments.

For example, the impact of the 2008–09 market crash attributed to the housing bubble bust leading to an overall market collapse cannot be accounted for in the Black-Scholes model (and possibly cannot be accounted for in any mathematical model).

But it did lead to the occurrence of many low-probability extreme events of high declines in stock prices, causing massive losses for option traders. The forex and interest rate markets did follow the expected price patterns during that crisis period but could not be shielded from the impact all across Black-Shole.

Regarding Dividends

The Black-Scholes model does not account for changes due to dividends paid on stocks. Assuming all other factors remain the same, a stock with a price of $100 and a dividend of $5 will come down to $95 on dividend ex-date. Option sellers utilize such opportunities to go short call options/long put options just prior to the ex-date (expiration) and square-off the positions on the ex-date, resulting in profits.

Traders following Black-Scholes pricing should be aware of these implications and use alternative models such as Binomial pricing that can account for changes in payoff due to dividend payment. Otherwise, traders should only use the Black-Scholes model for trading European non-dividend-paying stocks.

The Black-Scholes model also does not account for the early exercise of American options. In reality, few options (such as long put positions) do qualify for early exercises, based on market conditions. Still, traders should avoid using Black-Scholes for American options or look at alternatives such as the Binomial pricing model.

Why Is Black-Scholes So Widely Followed?

There are several fairly compelling reasons:

  • It fits very well with the popular delta hedging strategy on European options for non-dividend-paying stocks.
  • It is simple and provides a readymade value.
  • Overall, when the entire market, or most of it, is following it, prices tend to get calibrated to the ones computed from Black-Scholes.

The Bottom Line

Blindly following any mathematical or quantitative trading model leads to uncontrolled risk exposure. The financial failures of 2008–09 are attributed to the flawed use of trading models.

Despite the challenges, model usage is here to stay thanks to constantly evolving markets with a variety of instruments and the entry of new participants. Models will continue to be the primary basis for trading, especially for complex instruments such as derivatives.

A cautious approach with clear insights about the limitations of a model, their repercussions, available alternatives, and remedial actions can lead to safe and profitable trading.

Frequently Asked Questions

What Is the Black-Scholes Model?

The Black Scholes Model is a mathematical calculation used for pricing options contracts and other derivative financial instruments, using time value and other variables.

Who Uses the Black-Scholes Model?

The typical user is an options trader relying on its pricing model, which works best with European-style options.

Are the Black-Scholes Model and the Black-Scholes-Merton Model Different?

They are different names for the same mathmatical model for pricing options.

What Is the Black-Scholes Pricing Model for Options?

The Black-Scholes Pricing Model for options is a pricing model used to determine the fair price or theoretical value for a call or a put option based on six variables including volatility, option type, underlying stock price, time value, strike price, and the current risk-free rate.

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