Black-Scholes: The formula linked to the financial crash

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switesh
Posts: 527
Joined: Mon Jul 11, 2011 8:43 am

Am reading Buffett FAQ - A compendium of Q&As with Warren Buffett at the moment (385 pg document with mostly Tilson Notes from various BRK Annual Meetings). Came across the subject of Black-Scholes.

Here's what the world's greatest investors have to say about it:
CM: We don't blindly use Black-Scholes; we apply judgment.

CM: Black-Scholes works for short-term options, but if it's a long-term option and you think you know something [about the underlying asset], it's insane to use Black-Scholes.

WB: Charlie and I have thought about options all of our life. My guess is that Charlie was thinking about this in grade school. You don't have to understand Black-Scholes at all, but you have to understand the utility and value of options, and cost of issuing them -- a very unpopular topic in some quarters.

WB: The Black-Scholes model is an attempt to measure market value of options. It cranks in various variables, mainly past volatility of the asset involved, which are not the best judge of value. [For example,] Berkshire had a very low beta -- experts like to give complex Greek names to simple things -- but that doesn't mean the option value to anyone who understood it was lower than another stock with higher volatility.
As Charlie said, Black-Scholes can give silly results over longer term. Last year, we made one large commitment in which somebody on the other side was using Black-Scholes and we made $120 million. We love the idea of someone else using mechanistic formulas. They may be right 99% of the time, but we can pass 99 times and only invest the one time they're wrong.


CM: Black-Scholes is a know-nothing system. If you know nothing about value -- only price -- then Black-Scholes is a pretty good guess at what a 90-day option might be worth. But the minute you get into longer periods of time, it's crazy to get into Black-Scholes. For example, at Costco we issued stock options with strike prices of $30 and $60, and Black-Scholes valued the $60 ones higher.This is insane.
I never really understood the Black-Scholes equation all along, but in terms of long-term investing I now understand that the equation doesn't really stack-up.
Just the other day I made a note in my diary that Price and Value are two completely different things.
Hence, it now makes perfect sense that to use historic volatility to price an option at higher value (with higher volatility) is just nuts!
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