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All of the inputs of the BS model are forecasts. All of them can be wrong, and they have been wrong countless times. It’s like saying that your linear extrapola

All of the inputs of the BS model are forecasts. All of them can be wrong, and they have been wrong countless times. It’s like saying that your linear extrapolation for the stock market mostly works, except for the times it doesn’t.

JumpCrisscross 6y ago
> the inputs of the BS model are forecasts In the same way a rocket flight model is forecasting the arrangement of air molecules it’s about to run into. They’re instantaneous forecasts that are dynamically updated. No long-term forecasting involved. At the end of the day, options market makers haven’t blown up since the early noughties. (LTCM got sunk by non-options bets.) They are low-margin, low-risk businesses. It’s fun to talk about them like they’re black boxes. And traders trying to defend their compensation will keep pitching them that way to senior management. But options pricing is a boring, largely solved—if still interesting—problem.
- jzwinck 6y ago
  If options pricing is largely solved, do you think exchanges could provide an API where instead of specifying the price and quantity for hundreds or thousands of options on a stock, market makers could send a much smaller message containing their latest risk and model parameters, and have the exchange run a standard model internally to generate the quotes? Since the model to convert parameters to prices and quantities would be known in advance to all traders, the next step could be providing a feed of current parameters which traders could use to build their own view of the public book. They'd still need plenty of quotes published piecemeal as now (as not all quotes would be model-generated) but the messaging could be much more efficient, and that could lead to more options trading.
  - JumpCrisscross 6y ago
    > market makers could send a much smaller message containing their latest risk and model parameters, and have the exchange run a standard model internally to generate the quotes? No market works like this. The smaller-still message of a price is sent and disseminated. When you buy a flight, you want the price of the ticket—not the airline’s fuel and tariff costs.
FabHK 6y ago
None of the inputs to the BS model are forecasts, except the volatility. What the BS model allows, then, is trading this volatility. (Just as other financial products require other inputs, and thus make them, in a sense, tradable: Cross currency swaps make the cross currency basis tradable, credit default swaps make credit risk tradable, trading index vol versus single stock vol makes correlation tradable, etc.)
- whatever1 6y ago
  The only thing it offers, is a common denominator for trading. The value predicted by the model itself is completely arbitrary. You have no clue today about tomorrows volatility or the the interest of a “risk free” instrument aka the central banker can show up tomorrow announcing -10% interest rates. Btw when interest rates went negative for the first time, many trading shops were caught pants down, because of course their models did not have a provision for negative interest rates.

JumpCrisscross 6y ago

> the inputs of the BS model are forecasts In the same way a rocket flight model is forecasting the arrangement of air molecules it’s about to run into. They’re instantaneous forecasts that are dynamically updated. No long-term forecasting involved. At the end of the day, options market makers haven’t blown up since the early noughties. (LTCM got sunk by non-options bets.) They are low-margin, low-risk businesses. It’s fun to talk about them like they’re black boxes. And traders trying to defend their compensation will keep pitching them that way to senior management. But options pricing is a boring, largely solved—if still interesting—problem.

jzwinck 6y ago
If options pricing is largely solved, do you think exchanges could provide an API where instead of specifying the price and quantity for hundreds or thousands of options on a stock, market makers could send a much smaller message containing their latest risk and model parameters, and have the exchange run a standard model internally to generate the quotes? Since the model to convert parameters to prices and quantities would be known in advance to all traders, the next step could be providing a feed of current parameters which traders could use to build their own view of the public book. They'd still need plenty of quotes published piecemeal as now (as not all quotes would be model-generated) but the messaging could be much more efficient, and that could lead to more options trading.
- JumpCrisscross 6y ago
  > market makers could send a much smaller message containing their latest risk and model parameters, and have the exchange run a standard model internally to generate the quotes? No market works like this. The smaller-still message of a price is sent and disseminated. When you buy a flight, you want the price of the ticket—not the airline’s fuel and tariff costs.

FabHK 6y ago

None of the inputs to the BS model are forecasts, except the volatility. What the BS model allows, then, is trading this volatility. (Just as other financial products require other inputs, and thus make them, in a sense, tradable: Cross currency swaps make the cross currency basis tradable, credit default swaps make credit risk tradable, trading index vol versus single stock vol makes correlation tradable, etc.)

whatever1 6y ago
The only thing it offers, is a common denominator for trading. The value predicted by the model itself is completely arbitrary. You have no clue today about tomorrows volatility or the the interest of a “risk free” instrument aka the central banker can show up tomorrow announcing -10% interest rates. Btw when interest rates went negative for the first time, many trading shops were caught pants down, because of course their models did not have a provision for negative interest rates.