In 1973 Fischer Black and Myron Scholes published a research paper called “The Pricing of Option and Corporate Liabilities.” In the paper, the Black-Scholes option-pricing model was introduced. Before the model was released, there was no clear way to value option contract premiums.
Unfortunately, the model was designed for European-style, non-dividend paying stocks. If you recall from lesson 1.4, European-style option contacts can only be exercised at expiration, whereas American-style options can be exercised at any time before expiration. This obviously makes the Black-Scholes model imperfect.
Regardless, the model allows investors to value option premiums using a generally accepted formula. Since then, there have been numerous alterations. What exists today is a model that uses six input factors to create the theoretical value of an option contract. Of the six inputs, five of them are dynamic and one is fixed (strike price). This is what makes options unique to all other types of derivatives. Understanding the Black-Scholes pricing model is essential to any successful trader's education.
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