The Black-Scholes equation is a complex mathematical formula known as a partial differential equation. While the math behind this equation is pretty complex, there are calculators that you can find online that will do all of the math for you. In a nutshell, what the Black-Scholes Options strategy looks at is the true short term price of what an asset should be, and then looking at this price, you buy the appropriate option, either a call or a put, to put yourself in a position so that when the asset’s price moves toward the “true” price, you profit. This is a tough strategy, but when used correctly, it can be very helpful in growing your money.
Putting This Strategy to Work
The best way to use this strategy is to find a Black-Scholes calculator online. There are many of these, just do a quick Google search and you can search through the options and choose the one you like best. Next, input the data that is asked. This will include the current price of the asset, the price you expect the asset to move to, expiration date, volatility (often described as a percentage), dividend style (if any), and sometimes the yield (again, if any).
Once this data is put into play, you will be given a series of numbers. These will include terms like gamma, theta, vega, and rho, to name a few. While these numbers do have importance, in the context that we are looking at this strategy, you can skip them. The numbers that we are most interested in are the call and put numbers. The higher the number, the more favorable the trade is. So, let’s say you’re looking at Apple, and the company is currently priced at $97 per share. You expect that the company will go up over the coming week, and you expect that it will go up to $99. If you input these numbers in, accounting for current volatility, you will get a call number around 2.55 for the call. Typically, this would be something to stay away from in a traditional option, but with a binary option, it is a whole different ballgame. If your number is above 2, a weeklong call option is correct. If the number drops below this, then you avoid the trade.
The trick is to put the actual current price as the exercise price and the expected growth as the current stock price. Once this is done, you can see the value of your potential trade as it would be perceived by the Black-Scholes model. The higher the number, the better the trade is for you. Only use this in conjunction with accurate analysis on the expectations, though. When done correctly, it should confirm whether or not your trade has a strong chance of success or a weak one.
Things Can Go Wrong
Other than a huge need for accurate analysis in your initial data, the biggest drawback here is the complexity of the strategy. The Black-Scholes Model assumes that the person using it has a very firm grasp on volatility and how to measure it. Also, in a perfect world, it assumes that the assets that you are trading do not pay out dividends, such as many stocks do. When you use this in short term binary options, this change in outcome is minimal at best, but do beware that Black-Scholes cannot be used with high degrees of accuracy on long term trades with dividend paying stocks such as Apple, Disney, or Google as a result of this.
The other obvious drawback is the fact that although Black-Scholes is incredibly accurate and finding price inefficiencies, this doesn’t mean that the price will go back to where it should be in the given timeframe. You will find that inefficiencies are very common, but that doesn’t mean that it will be corrected in 60 seconds, or even 60 minutes. Black-Scholes is better used for long term binary options, which can tie your money up for longer than most people prefer.
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