3 Options Pricing Models — Which to Use and Why?
Choosing which Options Pricing Model to use depends on the exercise style:
❑ Black–Scholes is for European equity options, i.e. cash–settled products.
❑ Bjerksund–Stensland for American equity options, i.e. stock–settled products.
In either case, both pricing models are relevant for a product that does NOT have a dividend or a series of dividends. So, you still need to be mindful if the Index/ETF you are trading is stock–settled versus cash–settled, as both pricing models can be applied to dividend and non–dividend paying scenarios.
❑ Despite criticism against it (see article on the right), the Binomial model is adaptive in accounting for discrete cash flows from dividends and allows for full early exercise. It is relevant for American, European and Bermudan-style options with dividends.
A Bermudan style option is an American style option that permits exercise of that option only on certain specified days (always discretely spaced) during the life of that option (usually between the early exercise date and the expiration date). Effectively, an intermediate exercise style between an American option and an European option. The name originated from the pun of Bermuda being between America and Europe. Most exotic interest rate options are of Bermudan style.
So, make sure you know the exercise style of the underlying and choose the relevant option pricing model in your trading platform accordingly.
The Black–Scholes, Bjerksund–Stensland and Binomial models are the most commonly used in retail–based trading platforms. Not because they are simple to understand. There is nothing simple per se about applying mathematics to explain price versus market dynamics. At the same time, you do not to be a quantum physicist to figure out the mechanics of these models. They are adequate for home traders to use, as is. For more on the specific weakness which is a necessary insight into the use (and avoidance of abuse) of these models, see Price Indecision and Call–Put Pricing Disparity.
