Which Options Pricing Model Is Best?

A lot happens to options from the time they are listed until they expire. The factors that affect the value of an option prior to expiration include the following:

  • Implied Volatility: Changes in the expected movement during the term of the option will impact the value of the option
  • Time value: How much time goes by will impact some of the value of the option
  • Price Movement: The market moving closer or further from the strike price will impact the value of the option
  • Etc: Other factors impact options values but not nearly as much as the three listed above. We will focus on these three first.

To estimate the impact of these variables, options pricing models have been developed that take into account all of the factors that impact the value of options.While there are several models, it is beyond the scope of this course to differentiate the nuances of their pricing estimates. For now, it’s good to think of the various models in the same way a storm tracking model estimates the path of a storm.

The individual models are extremely precise in their predicted path. The cone is used to encompass a vast majority of the predictive paths while ignoring outliers and small deviations.

When it comes time to summarize and communicate the forecasted path, a cone is developed that encompasses most of the models. Even though each model provides a precisely predicted path. NONE of the models are right MOST of the time.

But together, they provide as good a range as we can expect.It’s the same with options pricing models. Some assume that certain values will accelerate when other changes occur. Other models assume a more constant change.

Over time, each will have their moments of better predictive nature of the change of the option value as the market move.

Some are adamant that certain models are more accurate.Here’s the author’s opinion based on experience.

There is little to no correlation between successful options trading and the model used by the trader.

In fact, many profitable options traders will trade their strategies without consulting a pricing model at all.

Just food for thought.

-Andrew Falde