Looking for an Alternative to Black-Scholes

The drawbacks of Black-Scholes are well-known and, while used in a limited way by some, the majority of trades find no value in the pricing model.

But there are other ways to calculate and model price.

First of all, what is the reason for pricing models? You want to know what, in theory, the option “should” be worth so you can better judge current premium as high or low. (In other words, maybe you really only need to track implied volatility of a specific option to decide this.) But beyond the basic need to know how to judge current premium, is there a better method?

The “risk-free interest rate” used by the B-S model is a huge problem. Can anyone explain what this is? In our modern debt security environment, what is a risk-free rate? B-S also assumes European style and no dividend, clearly not applicable to the majority of equity options traded today.

It occurs to me that a logical pricing model should be based on the fundamentals of the underlying security rather than on some universal “assumed” variables like risk-free rates. Because options are tied specifically to the underlying security, why should we use a broad assumption? For example, there may be a more reliable model of “return” based on return to investors mingled with the price of the underlying. The PE/book, for example, combines these elements. You have all of the elements: price of the stock, EPS, and tangible book value. This boiled-down return is perhaps much more suitable as a means for pricing options than the outdated B-S model.

Of course, this proposal requires a far-reaching analysis, testing, and creation of new formulation. Bring on the Quants. I welcome any further discussion on this question, including a defense of the B-S model if anyone cares to do so. I do not see any lasting value in basing assumptions of B-S and would prefer to track IV, perhaps coupled with a high probability criterion. There may also be much better and clearer methods for creating an underlying-specific rate of return that would be more reliable for pricing options.

Michael C. Thomsett

About this week’s Heavy Hitter: Michael C. Thomsett is a widely published options author, with six options books in print, published by John Wiley & Sons, FT Press, Amacom Books, and Traders Library. He blogs at FT Press, Minyanville, Benzinga and Seeking Alpha.