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The Black-Scholes Model: How Options Get Priced

Options and Derivatives • Beginner Investing • 7 min

What this lesson is about

The formula that made modern options markets possible, the five real-world inputs behind it, and a genuinely poignant footnote about who did and didn't win the Nobel Prize for it.

2 parts · a quick check after each · then the quiz

Part 1 of 2

The Black-Scholes model, published in 1973 by economists Fischer Black and Myron Scholes, with significant contributions from Robert Merton, is the foundation that made modern options markets possible. Before this model, pricing options was informal and less liquid. Options trading was a small part of the market. The model gave traders, market makers, and exchanges a clear, mathematical reference for an option's theoretical value.

The model uses five key inputs. The underlying asset's current price, the option's strike price, time until expiration, the risk-free interest rate, and volatility (the expected size of future price swings). Plug in those five numbers, and the model gives you a theoretical fair price for the option. Interestingly, this process is the reverse of how implied volatility is calculated: take the model's four inputs plus the actual market price, and then solve for the volatility that makes the equation work.

What an option paysBuy or sell, call or put. The kink is at the strike.

Quick check

Who is credited with developing the foundational options pricing model published in 1973, with significant contributions also credited to a third economist?

Part 2 of 2

Insider Angle: There's a poignant footnote here: Myron Scholes and Robert Merton won the 1997 Nobel Memorial Prize in Economic Sciences for this work, but Fischer Black, who also made significant contributions, did not receive the prize. He died in 1995, two years before it was awarded, and the Nobel Prize isn't given posthumously. There's another twist: Myron Scholes later became a principal at Long-Term Capital Management, the hedge fund that collapsed spectacularly in 1998. They used huge leverage on trading strategies partly based on the same quantitative models Scholes helped create. This story is discussed in another case study on this platform. The brilliance that changed options pricing didn't shield one of its architects from being part of a notorious hedge fund failure.
Try This: Research the basic assumptions behind the standard Black-Scholes model (like constant volatility and no dividends in its simplest form). Choose one assumption and explain, in your own words, a real-world situation where that assumption clearly doesn't apply.

Quick check

What are the five key inputs to the standard Black-Scholes options pricing model?

Quiz

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