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This equation is an idealized option, a spherical cow. If one would actually use it to price options one would lose money. There are many empirical option pric

• JumpCrisscross 3y ago
  > If one would actually use it to price options one would lose money If you try to fly a rocket across the solar system using only Newton's equations, it will crash. That doesn't make Newtonian mechanics useless. Almost every option-pricing engine in the market starts with Black-Scholes-Merton. Smiles and skews are all dealt with on the vol surface--it's an expandable variable.
  • KMag 3y ago
    One thing that seems not widely understood is that the assumption of normal or log-normal distributions in stochastic calculus is like the assumption of linearity in most engineering fields. It's known to be incorrect, but you can do a heck of a lot with piecewise-linear model. Similarly, using a normal or log-normal assumption within a range of parameters (such as the volatility smile) is really useful. Part of the reason a Gaussian distribution is used so much is that you need a stable distribution if you want to be able to perform algebra on your random variables. The variance of the Cauchy distribution is undefined and the variance of the Levy distribution is infinite, so Gaussian is really the go-to distribution.