Option traders use (very) sophisticated heuristics, never the Black-Scholes-Merton formula
AbstractOption 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.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.
Bibliographic InfoArticle provided by Elsevier in its journal Journal of Economic Behavior & Organization.
Volume (Year): 77 (2011)
Issue (Month): 2 (February)
Contact details of provider:
Web page: http://www.elsevier.com/locate/jebo
Options Option hedging Delta hedging Put-call parity Derivatives;
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- J-P. Bouchaud & M. Potters, 2001. "Welcome to a non-Black-Scholes world," Quantitative Finance, Taylor & Francis Journals, vol. 1(5), pages 482-483.
- Nicolae Garleanu & Lasse Heje Pedersen & Allen M. Poteshman, 2005.
"Demand-Based Option Pricing,"
NBER Working Papers
11843, National Bureau of Economic Research, Inc.
- Gigerenzer, Gerd & Todd, Peter M. & ABC Research Group,, 2000. "Simple Heuristics That Make Us Smart," OUP Catalogue, Oxford University Press, number 9780195143812.
- Merton, Robert C., 1975.
"Option pricing when underlying stock returns are discontinuous,"
787-75., Massachusetts Institute of Technology (MIT), Sloan School of Management.
- Merton, Robert C., 1976. "Option pricing when underlying stock returns are discontinuous," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 125-144.
- A. James Boness, 1964. "Elements of a Theory of Stock-Option Value," Journal of Political Economy, University of Chicago Press, vol. 72, pages 163.
- Stanley, H.E & Amaral, L.A.N & Gopikrishnan, P & Plerou, V, 2000. "Scale invariance and universality of economic fluctuations," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 283(1), pages 31-41.
- Breeden, Douglas T & Litzenberger, Robert H, 1978. "Prices of State-contingent Claims Implicit in Option Prices," The Journal of Business, University of Chicago Press, vol. 51(4), pages 621-51, October.
- Stoll, Hans R, 1969. "The Relationship between Put and Call Option Prices," Journal of Finance, American Finance Association, vol. 24(5), pages 801-24, December.
- Benoit Mandelbrot, 1963. "The Variation of Certain Speculative Prices," The Journal of Business, University of Chicago Press, vol. 36, pages 394.
- Mixon, Scott, 2009. "Option markets and implied volatility: Past versus present," Journal of Financial Economics, Elsevier, vol. 94(2), pages 171-191, November.
- Zimmermann, Heinz & Hafner, Wolfgang, 2007. "Amazing discovery: Vincenz Bronzin's option pricing models," Journal of Banking & Finance, Elsevier, vol. 31(2), pages 531-546, February.
- Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
- Kairys, Joseph P, Jr & Valerio, Nicholas, III, 1997. " The Market for Equity Options in the 1870s," Journal of Finance, American Finance Association, vol. 52(4), pages 1707-23, September.
- Timothy C. Johnson, 2013. "Reciprocity as the foundation of Financial Economics," Papers 1310.2798, arXiv.org.
- Nassim N. Taleb & Raphael Douady, 2012. "Mathematical Definition, Mapping, and Detection of (Anti)Fragility," Papers 1208.1189, arXiv.org.
- Godfrey Charles-Cadogan & John A. Cole, 2013. "Bankruptcy Risk Induced by Career Concerns of Regulators," Papers 1312.7346, arXiv.org.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Zhang, Lei).
If references are entirely missing, you can add them using this form.