price is determined largely by the operation of algorithms called “models.”
The original model that created the modern world of options trading was
the Black-Scholes options analysis model, which assumed the “fair value”
of an option could be determined by entering five parameters into the
formula: the strike price of the option, the price of the stock, the “risk-free”
interest rate, the time to expiration, and the volatility of the stock.
The eventual universal acceptance of this model resulted in the derivatives
industry we have today. To list all the forms of derivatives available for
trading today would be to expand this book by many pages, and it is not the
purpose of this book anyway. The purpose of this paragraph is to sternly
warn general investors who are thinking of “beating the derivatives
markets” to undergo rigorous training first. The alternative could be
extremely expensive.
At first, the traders who saw the importance of this model and used it to
price options virtually skinned older options traders and the public, who
traded pretty much by the seat of the pants or the strength of their
convictions, meaning human emotion. But professional losers learn fast and
now all competent options traders use some sort of model or anti-model, or
anti-antimodel to trade. True to form, options sellers, who are largely
professionals, take most of the public's (the buyers) money. This is the way
of the world.
Options pricing models and their importance
After the introduction of the Black-Scholes model, numerous other models
followed, among them the Cox-Ross-Rubinstein, the Black Futures, and
others. For the general investor, the message is this: he must be acquainted
with these models and what their functions are if he intends to use options.
Recall, the model computes the “fair value” of the option. One way
professionals make money off amateurs is by selling overpriced options and
buying underpriced options to create a relatively lower risk spread (for
themselves). Not knowing what these values are for the private investor is
like not knowing where the present price is for a stock; it is a piece of
ignorance for which the professional will charge him a premium to be
educated about. Unfortunately, many private options traders never get