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The Complete Guide To Option Pricing Formulas, and Derivatives, Models on Models (II)

One of my commenters wrote in response to my piece Book Reviews: The Complete Guide To Option Pricing Formulas, and Derivatives, Models on Models:

  1. Kurt Osis Says:
    David:

    How can advocate people using these models which clearly don’t work? Estimating volatility is a suckers bet. Even if you could estimate the underlying “actual” volatility with 100% accuracy there would be sample error in your realized volatility. And of course the volatility isn’t just changing, the fundamentals of the underlying are changing.

    I once heard of a man named Mandelbrot who said volatility was infinite, in which case these sigmas and lemmas are a bit beside the point, no?

Kurt, I’ve met Mandelbrot, and have discussed these issues with him.  The two books that I recommended are also up on those issues.  Implied volatility estimates as applied to option pricing formulas are a fall-out.  No one thinks they are true, but they are a paramater used to keep relationships stable across options of similar expirations.

Intelligent hedgers hedge options with options; they don’t try to apply the theoretical equivalence that lies behind the traditional Black-Scholes formula and do dynamic hedging with the common stock itself.  That is the philosophy behind the books that I reviewed.

I’m on your page, Kurt.  Variance is infinite, and B-S blows up.  But within the options world, there has to be a way of calculating relative value, and these books aid us in that calculation.

If you think I am wrong here, go to your local library, and get these books via Interlibrary loan.  Read them, and you will see that we are all in agreement.






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One Response to The Complete Guide To Option Pricing Formulas, and Derivatives, Models on Models (II)

  1. Kurt Osis says:

    I will concede the point, as I have not read these particular books. I have generally stopped reading books on options pricing as they all seem to make the same mistakes. (I fear they’ll contaminate my mind and I’ll begin to believe its actually possible to forecast volatility).

    I know many a financial engineer who will agree on principal that variance is infinite in the morning and then talk about “ten sigma moves” in interest rates in the afternoon. They seem to fail to see inherent contradiction.

    In reality if you hedge options with options (as I do), there is no need to estimate volatility at all.

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David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


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