Articles

Options Before Quants
By David Blitzer

Page 3 of 3

A major benefit of options embracing quant models is that the range of options and quantitative tools has expanded greatly since Black-Scholes. Two examples familiar to index investors are options on indexes led by the S&P 500 and VIX. A put on the S&P 500 is not the same as a put option on one’s entire net worth, but it is a lot more comprehensive than a put on a single stock. VIX comes full circle in offering new ways to use options to protect, or invest, in the market while returning information to the market from options priced in the market. Much remains that can be done with options to give people ways to insure or accept risks. Ten years ago, we all thought that real estate prices rarely drop. Now the idea of insuring the economic value of one’s home looks attractive. One idea is to use the S&P/Case-Shiller Home Price indexes puts for homeowners or calls for investors on home values. If one can insure against fire, it only makes sense to insure against a market collapse.

What does this all have to do with Amsterdam and Black-Scholes? Only this: Derivatives are thought of by some as weapons of financial mass destruction, a “new new thing” that contributed to the financial crisis and that are dangerous in the hands of unknowing investors.

But from another perspective, options—and options-linked products like the VIX—have been with us for centuries, and used properly, have the opposite effect. Like the old traders who used options on the Dutch East India Company because they couldn’t handle the risk of owning the stock, they are a way of limiting our downside, insuring against shipwrecks and protecting our portfolios from harm.

Endnotes
¹Black, Fischer and Myron Scholes, “The Pricing of Options and Corporate Liabilities,” 81(3)Journal of Political Economy, 1973, pp. 637-654.

²Geoffrey Poitras, “The Early History of Option Contracts,” Simon Fraser University, September 2008.

³William N. Goetzmann and K. Geert Rouwenhorst, “The Origins of Value,” Oxford University Press, September 2008.

⁴Robert Barro, “Rare Events and the Equity Risk Premium,” Harvard University, July 2005.