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Red-Blooded Risk: The Secret History of Wall Street by Aaron Brown

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Smile

One example is option smile and skew. Fischer Black, along with Myron Scholes and Robert Merton, had come up with an option pricing model in 1973 that was widely used on Wall Street. (Ed Thorp had developed a very similar model six years earlier, but he didn't publish it; he used it to make money.) Practitioners noticed that options on unusual events—say, that the stock market would rise or fall more than 20 percent over a month—tended to have higher prices than the model results. To a lesser extent, people noticed that option contracts that paid off in bad events, like a stock market crash, sold for more than options with the same model price that paid off in good events. Before October 19, 1987, this was always attributed to supply-and-demand forces. Lots of unsophisticated investors were willing to overpay to protect their portfolios, and professional traders made money selling the protection and hedging it. Selling the protection and hedging was known to be a risky strategy, but the conventional wisdom was that it had positive expected value.

By October 22, 1987, that conventional wisdom had reversed. Supply and demand did not cause irrational prices for options. It was now taken for granted that options on unusual events should sell for more, and options that paid off in bad events should sell for more than options that paid off in good events. If you graph the ratio of option price to model price by exercise price, the first effect looks like a smile. The options on ...

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