The Skinny On Options Modeling

Black Scholes vs American Options

The Skinny On Options Modeling

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

This segment is about the pricing difficulties using the Black-Scholes system for valuing in-the-money options with American style exercise. TP does the heavy lifting on the math and the viewer can sit back and benefit.

The Black-Scholes option modeling system was set up for options with European exercise. That means the options can only be exercised at expiration. Most options we trade are American style. They can be exercised at any time.

Most of the time there is little difference. Sometimes though the Euro style options will have a theoretical value below their intrinsic value and TP explains why and displays the math formulas. This won't happen with American options because of the arbitrage opportunity.

Variations on Black-Scholes attempt to account for the exercise difference in different ways. TP explains the methods. They converge on price on out-of-the money options. Black-Scholes works well for American options when interest rates and dividends are low.

The prices though don't always match up exactly. TP gives us an example using the SPY and the SPX options. He provides all the info and shows us the slight differences and explains why the prices differ.

Watch this segment of “The Skinny on Options Modeling” with Tom Sosnoff, Tony Battista and TP for a better understanding of how options are priced using the Black-Scholes system and the problems on pricing American style options using that.

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