Options - Alternative To Black-Scholes - by Michael C. Thomsett
Using the Black-Scholes pricing model for pricing options is not the best system for trade timing. Given the numerous flawed assumptions in Black-Scholes, traders may consider an alternative for selecting options and timing trades - for two reasons.
First, many systems are based on using options expiring in the very near future. However, if the selection is based on implied volatility analysis, this is an unreliable method. Volatility collapse in the last month of an option's life and especially at the very end. On the last trading day, "implied volatility will collapse smoothly throughout the day." (Jeff Augen, "Trading Options at Expiration", 2009).
Second, given the flaws in Black-Scholes concerning volatility as a fixed and unchanging factor (compared to rapid changes in actual volatility), the formula does not provide realistic or accurate pricing.
As an alternative, the question should be, Do you need a pricing formula to time options trades at all? If an analysis is performed based on the chart of the underlying security, improved timing is possible by observing the proximity of strong reversal and confirmation signals to resistance and support; strength or weakness of the preceding trend; and analysis of numerous different kinds of signals (traditional price patterns, candlesticks, moving average, volume indicators and momentum oscillators).
I performed a two-year study involving 587 options trades based on this type of analysis, which resulted in 91.6% of trades ending profitably, with average annual returns of 35%. This study is documented in my article, "Signal Correlation Applied to Charting Techniques: Conditions to generate consistently profitable trades" which is being published later this year in the peer-reviewed Journal of Technical Analysis (JOTA).
Please also look at my new article, "Using Value to Price Options" in the October 15, 2015 issue of Modern Trader.
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