The original Black-Scholes formula often is cited as the authoritative source for options pricing. However, with a large number of variables built into option formulae, it is surprising that they occasionally are close to approximating or matching market value.
The Black-Scholes formula as originally published was full of unrealistic assumptions. These include:
1. Volatility is fixed and never changes.
2. The short-term interest rate never changes.
3. Anyone can lend or borrow as much as he wants as long as he covers this with a portfolio that exceeds the level of borrowing.
4. A short seller will have the use of sales proceeds and net return, even if those proceeds are offered up as collateral.
5. No transaction costs apply to either stock or option trades.
6. Trades do not affect taxes that have to be paid.
7. Stocks do not pay dividends.
8. Options cannot be exercised early.
9. No events, like takeovers, will end the life of an option early.
These 9 flaws point out that the original formula did not account accurately for the variables that apply in pricing of options.
Michael Thomsett blogs at the CBOE Options Hub and several other sites. He is author of 11 options books and has been trading options for 35 years. Thomsett Publishing Website
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