Black Scholes Option Pricing Model Key Terms

Get to know the ins and outs of the Black Scholes option pricing model

By M. Krasniak, Freelance Writer/Editor

The Black Scholes option pricing model is used primarily to derive the correct market price of stock options. Options are contracts that give you the right, but not the obligation, to sell the asset named in the contract. They can also be a handy tool for managing the risk of a portfolio of stocks, currency futures or other financial assets. The Black Scholes option pricing model is mainly useful for European-style options. To help you navigate the world of this pricing model, here are some important key words to keep in mind.

Call option

A call option is a type of option that gets priced through the Black Scholes option pricing model. It allows you to buy the asset named in the contract at a predetermined price. This is the most common type of option, and you can use it in a variety of circumstances.
Try: Check out this financial dictionary on InvestorWords.com for a clear definition of a call option.

Put option

A put option is the counterpart to a call option and is the other type of option priced with the Black Scholes option pricing model. It allows the option owner to sell the underlying asset to the option seller at a predetermined price. This type of option is often used as insurance for a portfolio of stocks.
Try: BusinessDictionary.com not only gives you the definition of put option, but provides links to words that are related.

Volatility

Normally, volatility can be a dangerous thing, and that's why options can be so useful. However, that same volatility affects the value of an option. In the Black Scholes world, the more the price of the underlying asset can change, the more valuable the option.
Try: Investopedia has a comprehensive, in-depth discussion of volatility in options.

Delta

The value of the option is also sensitive to changes in the value of the underlying asset. In the Black Scholes option pricing model, the delta measures the level of that sensitivity. High delta means the option is very sensitive to changes in the value of the underlying asset.
Try: This discussion on Trader Soft will get you up to speed on delta and its uses.

Hedging

Options are ideal for hedging, which is a method of managing risk. If you have purchased the stock and are worried about price drops in the near future, you can hold put options to protect against that risk using the information provided by the Black Scholes option pricing model.
Try: Optiontradingpedia, an options encyclopedia, provides an excellent tutorial to learn all about hedging techniques.

European option

Options come in a variety of styles, often called "flavors." The Black-Scholes model is designed for European options. European options are characterized by the fact that they can be exercised only on the expiration date.
Try: The financial dictionary on TheFreeDictionary.com gives links to related words in addition to defining European option.