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.