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Former option trader here. The free parameter is actually the "thing" that you're actually trading when you trade an option. All the other parameters are just e

Former option trader here. The free parameter is actually the "thing" that you're actually trading when you trade an option. All the other parameters are just environmental, you look them up. The short story is that the implied vol is a sort of balancing price between how much the option loses in value over time vs how much you can make performing the hedge.

MuffinFlavored 3y ago
Why do any of the other variables matter if the market is collectively fighting between "overpriced and underpriced" on premium/implied volatility?
- kflansburg 3y ago
  You can find an IV that makes sense for a single option with invalid other parameters, but things will break down when you go to price other expirations / strikes. When trading, you don't want to wait to see an "updated" IV, you would want to respond directly to changes in important and well understood parameters like underlying price.
- sheepscreek 3y ago
  The Black-Scholes equation describes the unconscious biases that influence the price of options. It is able to beautifully separate the one quantity that every trader prices differently from the rest. That’s volatility. All the other factors, time including, are the same for everyone.
- lordnacho 3y ago
  They don't really matter. They are just things you look up in order to a get a number out for what the option costs in dollars.
eggdaft 3y ago
Was BS actually of any practical use? It just seems to be a fantasy like most maths in economics.
- lordnacho 3y ago
  Yes, it has some use. First of all, if you don't have a common model, it becomes impossible to talk about vol. So even if everyone uses their own model, they convert back into BS vol to talk about vol. Second, all models are wrong, but some models are useful. BS is a good starting point because it captures something that is relevant in option pricing, namely that uncertainty matters.

MuffinFlavored 3y ago

Why do any of the other variables matter if the market is collectively fighting between "overpriced and underpriced" on premium/implied volatility?

kflansburg 3y ago
You can find an IV that makes sense for a single option with invalid other parameters, but things will break down when you go to price other expirations / strikes. When trading, you don't want to wait to see an "updated" IV, you would want to respond directly to changes in important and well understood parameters like underlying price.
sheepscreek 3y ago
The Black-Scholes equation describes the unconscious biases that influence the price of options. It is able to beautifully separate the one quantity that every trader prices differently from the rest. That’s volatility. All the other factors, time including, are the same for everyone.
lordnacho 3y ago
They don't really matter. They are just things you look up in order to a get a number out for what the option costs in dollars.

eggdaft 3y ago

Was BS actually of any practical use? It just seems to be a fantasy like most maths in economics.

lordnacho 3y ago
Yes, it has some use. First of all, if you don't have a common model, it becomes impossible to talk about vol. So even if everyone uses their own model, they convert back into BS vol to talk about vol. Second, all models are wrong, but some models are useful. BS is a good starting point because it captures something that is relevant in option pricing, namely that uncertainty matters.