Imagine what your life could be like if for any situation you could enjoy the upside without suffering any of the downside. Say you love the color yellow, but it totally washes out your skin tone. Or, perhaps you really want to Keep Up With The Kardashians but unfortunately there aren’t enough hours in the day to follow the entire family’s Instagram accounts. It seems like all choices we have in life have a downside, but what if I told you that in financial markets there are contracts with no downside? No, I’m not trying to sell you timeshares. I’m talking about options pricing.
Options are contracts that allow investors to buy or sell stock for a specific amount, known as the strike price, by a specific date. For example, if you buy a stock today, the price could drop in the future and you could lose money. But if you buy an option, you purchase the right to sell the stock at an agreed upon price in the future. If the stock drops, you have insurance. If the stock rises, you profit. Options provide an effective way to control for risk. Pricing options, however, posed a challenge to economists. No one could agree on a standardized method. How much should an investor pay for such absolute peace of mind?
Myron Scholes and his colleague, Fisher Black, were fascinated by the idea of options and the way to take the upside without the downside to any trade. They sought a formula that would calculate the correct price of an option at any moment in time just by knowing the current price of the stock. Economists had previously come up with formulas that incorporated the agreed upon elements necessary to value an option: the stock price, its volatility, the strike price, the duration of the contract, the interest rate, and the overall riskiness of the option. They were all measurable except one – the level of risk. So Black and Scholes decided if they couldn’t measure the risk of an option exactly, perhaps they could somehow make it less significant. The method they devised became one of the most important discoveries in economics, eventually winning its developers the prestigious Nobel Prize.
Scholes and Black started with the old idea of hedging, in which gamblers would limit the risk exposure of a bet by placing it in the opposite direction. They created a theoretical portfolio and whenever stocks or options fluctuated up or down, they tried to cancel the movement out by making another risky move in the opposite direction. Their aim was to keep the overall value of the portfolio in perfect balance.
We all hedge risky actions daily. You might be catching feelings for the girl you’ve been seeing, so you keep your Bumble account active just in case she ghosts you. Or you might crush your SoulCycle class, but then go to a bottomless brunch to protect your body from the shock of supreme health. It’s hard work keeping the overall value of your self-worth in constant stasis.
Since prices, like most events, move at random, at first Black and Scholes could cancel out only small fluctuations using this method. But eventually, armed with complex mathematics and a mass of calculations, they found they could precisely balance out virtually any movement using a strategy called dynamic hedging. Black and Scholes had found a theoretical way to neutralize risk. Now, risk dropped out of their equation. Without risk – the unmeasurable element – they finally had a mathematical formula, which could give them the price of any option. If only there was a quantitative solution to help me look good in yellow and keep up with celebrity gossip without having to hide my internet browser at work.