Option Traders Use (very) Sophisticated Heuristics, Never the Black–Scholes–Merton Formula
Espen Gaarder Haug
affiliation not provided to SSRN
Nassim Nicholas Taleb
NYU-Tandon School of Engineering; New England Complex Systems Institute
February 26, 2009
Journal of Economic Behavior and Organization, Vol. 77, No. 2, 2011
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 contra- diction 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.
Number of Pages in PDF File: 11
Keywords: Option pricing, put-call parity, delta hedging, Black-Scholes-Merton, Bachelier, Thorp
JEL Classification: G12, G13
Date posted: September 11, 2007 ; Last revised: November 16, 2012
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