Daily Archives: October 3, 2013

Option Traders Use (very) Sophisticated Heuristics, Never the Black–Scholes–Merton Formula

I notice a lot of viewership of the item posted by RichardH, Humor–Myron Scholes on the best way to reduce risk.

I thought I would add a different point of view, just in case anybody is wondering.  I was reading the Antifragile book by Nassim Nicholas Taleb, and he mentions Black, Scholes, and Merton several times.

Below is the citation of a technical paper Taleb coauthored.

Haug, Espen Gaarder and Taleb, Nassim Nicholas, Option Traders Use (very) Sophisticated Heuristics, Never the Black–Scholes–Merton Formula (February 26, 2009). Journal of Economic Behavior and Organization, Vol. 77, No. 2, 2011. Available at SSRN: http://ssrn.com/abstract=1012075

Here is the abstract that is available at the link just above.  The abstract gives a rather mild view of what Taleb thinks of Black, Scholes, and Merton.

Option traders use a heuristically derived pricing formula which they adapt by fudging and changing the tails and skewness by varying one parameter, the standard deviation of a Gaussian. Such formula is popularly called “Black–Scholes–Merton” owing to an attributed eponymous discovery (though changing the standard deviation parameter is in contradiction with it). However, we have historical evidence that: (1) the said Black, Scholes and Merton did not invent any formula, just found an argument to make a well known (and used) formula compatible with the economics establishment, by removing the “risk” parameter through “dynamic hedging”, (2) option traders use (and evidently have used since 1902) sophisticated heuristics and tricks more compatible with the previous versions of the formula of Louis Bachelier and Edward O. Thorp (that allow a broad choice of probability distributions) and removed the risk parameter using put-call parity, (3) option traders did not use the Black–Scholes–Merton formula or similar formulas after 1973 but continued their bottom-up heuristics more robust to the high impact rare event. The paper draws on historical trading methods and 19th and early 20th century references ignored by the finance literature. It is time to stop using the wrong designation for option pricing.

The Reign Of Morons Is Here

Esquire has the item The Reign Of Morons Is Here.  About the mildest quote I could find to excerpt here is the following:

We have elected an ungovernable collection of snake-handlers, Bible-bangers, ignorami, bagmen and outright frauds, a collection so ungovernable that it insists the nation be ungovernable, too. We have elected people to govern us who do not believe in government.

Well, I don’t “believe in the government” either, but I do have an understanding of what we might need to do by banding together, forming a government, and having it perform certain necessary functions.

The point that I keep on insisting on is the following:

The first and most important thing is to recognize how we came to this pass. Both sides did not do this. Both sides are not to blame.

And to think it all started with Ronald Reagan.

Thanks to RogerS and JoãoG for posting this on their Facebook pages.

Half the Republicans You Know Are Insane

In the spirit of this blog being unfair and unbalanced and deviating a little from the motto Extremism is the Enemy of Rationality, I bring you the Truth Out article Half the Republicans You Know Are Insane.

When asked if Muslims are working to implement Sharia Law in America – the harshly medieval seventh-century Islamic code best represented by the Taliban in Afghanistan, the Wahabists in the ranks of al Qaeda and (shhhh) a significant portion of the rebels in Syria – 44% of Republicans said it was true. If you know five Republicans, once again, two of them believe this, and a third is halfway convinced. Um…how? Where? In what way? Because women can now get free contraception and gay people have the same rights as you do? You think the Taliban is down with that?

The other examples in the article are just as entertaining as the one above.