Black-Scholes (idea)

A few notes:

• The only variable to Black-Sholes that cannot be measured from the market is the volatility of the underlying, as the volatilty in question is the volatility from the present to the expiration of the option.
• The theory can be worked in reverse, using the market price of the option as an input, and getting out a volatility figure. This volatility is called implied volatility.
• The theory is immensely popular. Some people believe it mostly works because people use it so much to determine what they want to buy. Another sign of its popularity is that in some markets, prices are usually quoted as implied volatility (using Black-Sholes) instead of directly.
• The theory assumes that the distribution of future prices is a Gaussian curve around the present price. This is a simplification; securities prices have a "fat tailed" distribution, meaning that extreme price moves are more likely than in a gaussian distribution (extreme moves down are also more likely than extreme moves up.)
• The theory assumes that dividends are paid continiously (which they are not.)