156  •   The Intelligent Option Investor
I’ll break the process into three steps:
1. Create a BSM cone.
2. Overlay your rational valuation range on the BSM cone.
3. Look for discrepancies.
Create a BSM Cone
The heart of a BSM cone is the forward volatility number. As we have seen, 
as forward volatility increases, the range of future stock prices projected by 
the BSM (and expected by the market) also increases. However, after hav-
ing looked at the market pricing of options, we also know that a multitude 
of volatility numbers is available. Which one should we look at? Each strike 
price has its own implied volatility number. What strike price’s volatility 
should we use? There are also multiple tenors. What tenor options should 
we look at? Should we look at implied volatility at the bid price? At the ask 
price? Perhaps we should take the “kitchen sink” approach and just average 
all the implied volatilities listed!
The answer is, in fact, easy if you use some simplifying assumptions 
to pick a single volatility number. I am not an academic, so I don’t neces-
sarily care if these simplifying assumptions are congruent with theory. 
Also, I am not an arbitrageur, so I don’t much care about very precise 
numbers, and this attitude also lends itself well to the use of simplifying 
assumptions. All we have to make sure of is that the simplifying as-
sumptions don’t distort our perception to the degree that we make bad 
economic choices.
Here are the assumptions that we will make:
1. The implied volatility on a contract one or two months from expi-
ration that is ATM or at least within the 40- to 60-delta band and 
that is the most heavily traded will contain the market’s best idea 
of the true forward volatility of the stock. 
2. If a big announcement is scheduled for the near future, implied 
volatility numbers may be skewed, so their information might 
not be reliable. In this case, try to find a heavily traded near ATM 
strike at an expiry after the announcement will be made. If the 
announcement will be made in about four months or more, just try