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Before Black-Scholes gets bashed too hard, people should keep in mind that it's nearly 50 years old. Of course it's going to be outdated and inaccurate (as all models are).

It's worth reflecting on what options markets were like before Black-Scholes: a lot smaller and valued through qualitative, "over-the-counter" measures. More like handshake one-off business deals than liquid markets.

Regardless of how you feel about options trading or the role of liquidity in financial markets, Black-Scholes was an intellectual achievement and should be remembered as such, even as newer better techniques replace it.

To his credit, Ed Thorp also realized this at the same time as Black-Scholes but chose the money-management route and didn't feel the need to publish his strategies as papers for the academic community (and probably giving up the Nobel Prize in Economics).

My two favorite books on these people are Perry Mehrling's biography of Black and Ed Thorp's autobiography.

Fischer Black: https://www.amazon.com/Fischer-Black-Revolutionary-Idea-Fina...

Ed Thorp: https://www.amazon.com/Man-All-Markets-Street-Dealer/dp/0812...

⬐ viburnum

There’s an excellent book called “An Engine, Not a Camera: How Financial Models Shape Markets” that lives up to its title.

⬐ SilasX

>Before Black-Scholes gets bashed too hard, people should keep in mind that it's nearly 50 years old. Of course it's going to be outdated and inaccurate (as all models are).

But the part about money having a positive time value shouldn't be. That indicates a major problem in the system.

⬐ cm2187

Even more modern models like SABR got broken by negative rates and the quants adjusted in the same way, they just shifted it.

⬐ camjohnson26

Myron Scholes was heavily involved in LTCM, a hedge fund whose strategy was to apply statistical models to trading. It was one of the most spectacular business failures of the last few decades, losing $4.5 billion in value.

https://en.m.wikipedia.org/wiki/Long-Term_Capital_Management

⬐ cheez

In their defense, they were fine until they stopped paying attention to risk and correlated positions.

So this isn't a knock on the BS model necessarily, but human greed.

⬐ yellowstuff

It's true that they were very profitable for several years, and then lost a ton of money at the end. Some of their worst losses were due to "style drift" into strategies that they were not experienced in, such as an unhedged bet on the Russian ruble before it was devalued. However, their core strategies involved exploiting very small profits with 25X leverage. Very few strategies can survive with that much leverage. Obviously a 4% decline in asset prices wipes you out, but in the case of LTCM it didn't take that large of a move. Since they were large and well-known when they started to lose money other traders figured out their positions and bet against their specific positions, knowing that LTCM would be forced to sell.

This is all from the excellent book "When Genius Failed."

⬐ cheez

Also true

⬐ MR4D

“How did you go bankrupt?

Two ways. Gradually and then suddenly.”

⬐ navigatesol

>It was one of the most spectacular business failures of the last few decades, losing $4.5 billion in value.

How quaint. In 2019, tech companies burn through billions of dollars of capital every single year, and we call them business "successes".

⬐ throwaway66920

While there’s lots to complain about this practice, those aren’t really the same thing. Tech firms are losing cash but generally gaining value towards an IPO. Whereas the investments were simply losing value.

⬐ Supermancho

> It was one of the most spectacular business failures of the last few decades, losing $4.5 billion in value.

> Tech firms are losing cash but generally gaining value towards an IPO.

...but they don't always. This makes the original statement sensationalist nonsense as it's happened multiple times (over the time period mentioned).

Valuation is screwed up in both "types" of businesses, but the methodology is irrelevant to the claim when it's apples to apples for the market.

⬐ georgeecollins

But the government hasn't yet needed to bail out a VC, a Unicorn or a stockholder. Each may lose money, but that happens all the time.

In the case of LTCM the government needed to bail out LTCM positions. That is why it is different.

⬐ MR4D

That’s incorrect.

I quote, “ Technically, the Fed didn't bail out LTCM. It used no federal funds. It merely brokered a better deal than the one Buffett offered.”

From https://www.thebalance.com/long-term-capital-crisis-3306240

⬐ roenxi

Although true, the money that the tech companies are burning through is probably related to the bail-out money that the trading firms are getting.

The banks keep dealing with high levels of leverage. It keeps predictably blowing up in their faces. The government/Federal Reserve is responding by making it easier to borrow money and then VC/Unicorns etc borrow.

The links aren't perfectly causal, but I bet that under normal conditions (if interest rates were allowed to rise into the 2-6% band in a sustained way and the government stopped handing out free money) then suddenly the unicorns would be subjected to market logic such as a need to make money to receive a high valuation.

⬐ agar

Losing $4.5B in value really understates the impact LTCM's failure had on the public markets.

Multiple wall street firms (at US Government urging) needed to urgently inject massive capital into the markets to contain a near-systemic collapse.

PBS produced a phenomenal documentary, The Trillion Dollar Bet[1], which covers the development of Black-Scholes and the rise and fall of LTCM. Highly recommended.

[1] http://watchdocumentaries.com/trillion-dollar-bet/

Speaking of Fischer Black, while he worked quite a bit because he enjoyed it and was given a lot of flexibility due to his reputation, he took great pride in having the smallest percent ownership in Goldman Sachs out of any of the partners while he was there.

He was not a banker himself, and was known to play Super Mario Bros. in his office and spend his evenings at comedy clubs. And he had a bigger impact on finance than arguably any banker since JPMorgan, without working their hours.

Perry Mehrling wrote a great biography of Black which I can't recommend enough.

http://www.amazon.com/Fischer-Black-Revolutionary-Idea-Finan...

Check out "My Life as a Quant" by Emanuel Derman http://www.amazon.com/My-Life-Quant-Reflections-Physics/dp/0... and this book about Fischer Black's (of Black Scholes) work in finance. http://www.amazon.com/Fischer-Black-Revolutionary-Idea-Finan...