In this month's Portfolio magazine, Michael Lewis wonders if the Black-Scholes formula -- the formula used to calculate and manage risk throughout the financial world, including determining the risk of trade positions and hedging strategies -- is flawed.
The Black-Scholes formula is an advanced mathematical formula generally credited with revolutionizing options pricing. Its assumptions are the basis for short trades and options designed to protect a trader against losses, no matter how much the market falls.
However, as Lewis outlines, while the formula has been good, it is not perfect, as evidenced by the October 1987 stock market crash, when traders and institutions learned that even with Black-Scholes techniques deployed, when the market is crashing and no one is willing to buy, it's impossible to sell short. The outcome? On "Black Monday," the Dow Jones Industrial Average plunged 508 points or 22.6% on October 19, 1987.
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