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Finance allah shmoop What is the black scholes model All

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right people Yeah it sounds like something that has to

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do with xu fashion right Black scholes are all the

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rage in paris this year only instead of a bright

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red soul there's is black and there isn't a doctor

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in there as well right Somewhere Okay Okay The black

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scholes stock option valuation model is actually a mathematical formula

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and a whole system for coming up with stock option

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prices for example disney's trading at a hundred bucks a

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share today You see i owe our chief investment officer

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of the milwaukee cardiologists investment club wanted by a call

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option on disney with a strike price at one hundred

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twenty bucks which won't expire for about four months Why

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do you want to buy this Why do you want

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to compete against goldman sachs Best and brightest people who

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make twenty five million dollars a year Not really sure

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about that But regardless you all believe disney is going

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to spike in its stock price the next four months

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And you want to take advantage of it Well how

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much should that hundred twenty dollars Strike stock option cost

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Expires in four months All right this call option is

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notably an american style option that is in american cell

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option You can sell the option any day until it

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expires And traditional black scholes modeling is based on the

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european style option which expires on lee on one day

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at the very end of the period in which the

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option is alive Got it So keep the approaching where

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you gotta think about american sell options are worth more

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because while you have more options in the option so

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the valuations to be a little bit different paying on

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which continent you're rolling the call option dice disney is

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a global company right But here we just want to

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give you the basic gist of how black scholes works

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conceptually and save the math for a more advanced video

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The key idea is that the more volatile the stock

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the more volatile should be the call option underlying it

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and a different strike price is relative to the existing

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stock will have all come mine's a more volatility to

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him as well if you think about it if they

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were looking at one hundred dollars strike price option with

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the stock at one hundred that'd be really volatile Where

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as if they were looking at a one hundred fifty

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dollars strike price option Well that'd be pretty cheap and

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pretty much stay cheap Whether disney was one hundred box

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one hundred five hundred ten ninety nine who wouldn't matter

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Still be cheap because so far out of the money

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right And yes there tons of mathematical errors in the

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black scholes model not least of which is the fact

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that past performance of stocks is not necessarily any indication

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of future performance yet That's what black scholes uses teo

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calculate its volatility here so we got all kinds of

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problems going in Problem is we have nothing better No

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other better option methodology to value things So we used

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black scholes Alright so since we have no other ways

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to navigate our future prognostications i've been driving a car

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by looking in that rear view mirror Well then here's

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what we do essentially the black scholes model takes an

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average waiting of a stock price over a given duration

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and multiplies it by some formula based on its volatility

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So here's a stock with very low volatility last couple

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of years Check out the line graph for a t

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and t kind of a snoozer doesn't really grow in

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only sits there pays a dividend and phone prices are

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getting cheaper It's called skype Okay but here's another that

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has been a hoot of a ride for the good

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the bad the ugly in the form of quotient a

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digital coupon and company Really volatile rocky mountains peaks valleys

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all kinds of stuff Good bad ugly Well you can

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imagine that a call option price with a strike price

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twenty percent above it and tease price would not be

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very expensive because given the low volatility of at and

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t stocked the odds that that's stock itself suddenly breaks

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out above that twenty percent line that was pretty low

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It hadn't done it much in the past And when

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it did it on lee did it by a very

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small amount So if you were writing life insurance against

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the financial death thing he broke out of that twenty

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percent line Well pride wouldn't charge too much for it

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right But then if you look at quotient well a

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price twenty percent above well here or here here seems

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highly likely because the stock trades in huge gaps up

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and down of a few percentage is a day i

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e the same volatility per day that a teen t

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has per month So if you are the person writing

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that call option or selling that call option to these

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kind of loving people in milwaukee or people like him

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and knowing that it would put you on the hook

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to provide shares at a price roughly twenty percent above

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where the stock is currently trading well of course you

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would charge the call option buyer of quotient ah whole

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lot more than you would charge the call option buyer

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of a t and t for that twenty percent above

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the stock price call option that expired at the same

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time Well the question then that black scholes tries to

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answer is just how much more you would charge for

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the highly volatile or high beta quotient stock option versus

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that of tea If you really care about the math

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well then a We're sorry B you should probably take

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a real investing course Not this one and go to

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real business school and see you may need a hobby 00:05:09.79 --> [endTime] We suggest golf or or needle point I'm going

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