Black-Scholes model is used to find the theoretical value of a call or put option on the basis of the following, namely volatility, option type, underlying stock price, risk-free rate, strike price, time etc. All possibilities of arbitrage are completely wiped out as there is less speculation and proper pricing of options as compared to derivatives.
Options traders who purchase options priced as per the formula calculated value and sell options which are priced higher than the one calculated by Black-Scholes Model.
It is also known as Black-Scholes-Merton formula and was the first model used for pricing of options. The formula was developed by three well-known economists-Fischer Black, Myron Scholes and Robert Merton. It is based on the following assumptions:
- Option is European and is exercised at the time of expiration
- During the life of the option, no dividends are paid
- Markets are efficient
- Buying of options involves no transaction costs
- Returns on the underlying asset are distributed normally
- Risk-free rate and volatility are constant and known for the underlying asset