Robert Merton: Finally, The Real Key to Making Cheddar (And Possibly Causing Recessions)

So… we admit Alex gave you the ol’ bait ‘n switch with his post on Harry Markowitz, who basically came up with the sound advice that we shouldn’t put all our eggs in one basket. He teased saying that this was the “key to making cheddar.” You thought he was going to teach you how to make money.

I will not tease you. I will now share the best cheddar-makin’ advice I’ve ever been privy to — stock options or options trading.

I will not pretend to teach you how to buy and sell options in the stock market. For that, you’re on your own. However, the possibility of even buying and selling options is all thanks to Robert Merton (along with Myron Scholes and Fisher Black) and their game-changing pricing formula.

Robert Merton in 1977, changing the finance game forever

Robert Merton and Myron Scholes split the Nobel Prize in 1997 for “their new method of determining the value of derivatives.” Fisher Black would have been part of this split, but unfortunately passed away before the prize was awarded. Their Black-Scholes-Merton formula revolutionized the options trading market. It became the standardized method of pricing these option trades. Today, this formula is already installed in your basic financial calculator!

Okay, so what are options?

Options are simply bets. We bet that things will happen (or not happen) all the time. We bet on horses and the Orlando Magic. We bet when we play cards. We bet on pretty much everything.

Near and dear to my heart is the blackjack table. When you play a round of blackjack, you “buy in” for say $10 in hopes that the dealer show cards that add up to 21 earning you some big money, right? Similar to the blackjack table, options allow you to “buy in” with the hopes that the stock price will either increase or decrease to a certain price by a certain date. The most you can lose is the cheddar you used to buy in.

The underlying beauty of stock options is that you have the potential to make some serious money, while binding your losses, i.e. — covering your a$$. Think of car insurance. When we purchase insurance, we are “buying in” the amount of our monthly premium, say around $1,000, for a car worth $20,000. The most we lose is the $1,000, but we can “win” $20,000 if we total our car.

Have you ever wondered how insurance agencies price how much to charge you for insurance? They put in information about you such as your age, value of the car, and your location into a formula that spits out a price taking into account the risk of insuring you.

In the same way, the Black-Scholes formula prices out the risk of options by taking into account the volatility of the stock, the time span, and the price of the stock.

Investment Inception

This surprisingly accurate formula hit the ground running in the finance world. If you think of the stock market as a betting market, Merton and friends created a betting market within the betting market. You weren’t simply betting on whether a company would do well, but betting on actual prices that are subject to random fluctuations. By simply plugging in some numbers into the formula, this pricing mechanism created “an investment inception”.

But just as easy as it was for Dom Cobb (Leonardo DiCaprio) to get lost in different layers of dreams in the Academy Award Winning movie Inception, options traders seem to experience the same thing in the finance world.

This “investment inception” is called the derivative market. Many folks blame this market as one of the main culprits causing the financial crisis in 2008. “Shadow banking” is where a lot of this derivative action was played out. People were making bets on bets; borrowing money to make more bets on those bets. The inevitable result: spiraling out of control when the housing bubble popped just like Cobb.

Everything’s fine…

It’s still alive and well

Whether or not the financial crisis was caused by the derivative market and options trading — options are still an option today! Notably, Robert Merton has applied this formula to a bunch of different markets, from housing to student loans. It sounds crazy, but it actually works. Time and time again, this formula proves to be the most reliable way of pricing stock options. Computers now do it all for you, so you just have to click a couple buttons instead of doing the math (Yay! No math!).

So, instead of just imagining your pockets getting heavier with wads of cash, you can make it a reality thanks to these Nobel laureates.

**Covering My A$$

If you dive into options trading and lose all your money, blame Merton and friends.

If you dive into options trading because of this article and start making a killing, you can show your thanks to me in the form of Bitcoin.

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