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.

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