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    Last Update : 07/17/2024   

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Article: "Why We Have Never Used the Black-Scholes-Merton Option Pricing Formula"

Authors: Espen Gaarder Haug & Nassim Nicholas Taleb, Nov 2007 - Third Version

Source: Social Science Research Network


Options traders use a 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) 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) 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 by using put-call parity. The Bachelier-Thorp approach is more robust (among other things) to the high impact rare event. It is time to stop calling the formula by the wrong name. The paper draws on historical trading methods and 19th and early 20th century references ignored by the finance literature.