Thursday, November 29, 2007

Do you know the secret to stock options?

The stock market has been on a crazy ride recently. First it was 10% down, then in two days made its biggest advance in five years. It can make one dizzier than an astronaut on a daily commute to space.

Some folks don't want the actual ride; they only want to benefit if the market - or a particular stock - reaches and passes a certain price. They pay for the option to buy or sell at a particular price within a certain amount of time.

The Black-Scholes formula revolutionized the pricing of options. First published in 1973, it is now widely used on Wall Street. But it has its limitations: assumptions include no transaction costs, risk-free lending, no dividends, and measuring volatility as a constant.

Alas these assumptions mean that Black-Scholes is at best an approximation to reality. And its misapplication may not only spell disaster for investors. With the current situation in sub-prime mortgage debt and real estate devaluation, maybe a better name might be black holes.

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