Trading Volatility

Abstract

The Black-Scholes equation and its solution is one of the triumphs of financial economics. It is a social-science model, an attempt to describe the unpredictable behavior of a stock price and the value of options that depends on that price.Taking the model seriously allows traders to treat the volatility parameter in the model as an asset and trade it by buying or selling a portfolio of options.The model and its extensions are genuinely useful and yet always inaccurate; they always eventually fail. The failures, paradoxically, trigger further extensions to the model that provide new parameters to reify and trade, but which will also eventually fail.

Keywords: volatility, options

JEL Classification: G13, G12