Trillion-dollar Industries: Options & Black-Scholes
A single mathematics equation kicked off not one, but four multi-trillion-dollar industries that completely transformed how we think about risk.
The crazy part? This game-changing equation originated from some unlikely places - like studying how heat transfers, beating the casino at blackjack, and figuring out why microscopic particles jiggle around randomly (Brownian motion). An unlikely bunch ended up cracking the code on making fortunes from it too - physicists, mathematicians, and scientists rather than stock traders.
The earliest known options were bought around 600 BC by the Greek philosopher Thales of Miletus. He believed that the coming summer would yield a bumper crop of olives. To make money off this idea, he could have purchased olive presses, which, if you were right, would be in great demand, but he didn't have enough money to buy the machines. So instead, he went to all the existing olive press owners and paid them a little bit of money to secure the option to rent their presses in the summer for a specified price. When the harvest came, Thales was right, there were so many olives that the price of renting a press skyrocketed. Thales paid the press owners their pre-agreed price, and then he rented out the machines at a higher rate and pocketed the difference. Thales had executed the first known call option.
In the late 1800s, French mathematician Louis Bachelier had to take a job at the Paris Stock Exchange to support his family. Observing the chaotic trading floor made him realize that stock prices follow a random walk, just like the erratic movement of particles in Brownian motion. Options can be an incredibly useful investing tool, but what Bachelier saw on the trading floor was chaos, especially when it came to the price of stock options. Even though they had been around for hundreds of years, no one had found a good way to price them. Traders would just bargain to come to an agreement about what the price should be. Applying physics principles, he derived the first formula for accurately pricing stock options.
Fast-forward to the 1970s, and economists finally built upon Bachelier's work to create the legendary Black-Scholes(-Merton) equation for option pricing. This was adopted by Wall Street faster than you can say "get rich quick." In fact, it was the quickest adoption of an academic concept in history - it enabled the explosion of multi-trillion-dollar markets for options, derivatives, securitized debt and more. Being able to find patterns of behaviour in this randomness spawned massive hedge funds, led by mathematicians and physicists, that were able to arbitrage the difference between Black-Scholes implied options prices and market prices of those very options. Ed Thorp’s (the pioneer of blackjack’s card counting methodology) Ridgeline and Princeton funds annualised over 20%, and Jim Simons’ Medallion fund made an incredible 66% per year for 30 years by using cutting-edge data science.
Modern-day managers have come full circle - from explaining the randomness and chaos to now finding the remaining predictable patterns within it to make money. However, the mathematics of Black-Scholes(-Merton) transformed our relationship with risk and volatility forever, even creating trillion-dollar industries out of thin air!
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