I told you BS was BS!

[SunTrader]

We all know Newton's laws are just first order approximations to Einstein's laws of special and general relativity. But, I can still use Newton's laws to fly an airplane, guide a ballistic missile, control a satellite.... Unless I model the Universe, I don't need general relativity.

True, but isn't the point of doing something is ... to do it well?

Well as in get better and better, not just good enough.

 

[ironchef]

True, but isn't the point of doing something is ... to do it well?

Well as in get better and better, not just good enough.

It is a generally accepted practice, even in engineering. You take a very complex system, develop first order approximation, usually a close form solution, then if more accuracy is needed, you add second order terms... BS is exactly the same, a first order close form solution.

 

[smacdtrader]

SMAcd admits that hasnt traded options..
SMAcd boasts that he can outperform BS..

How do you outperform a Model that spits out a value?? Its a theoretical value,not an indicator..

What's next,he going to boast he can outperform Discount Cash Flow analysis??

And admit he doesn't trade stocks..

ok. So while @ironchef definitely summed my point way better than I did. I now totally get what @taowave and @poopy are saying (even if poopy is a grumpy anger ball).

And indeed I was ignorant of the use case because of my inexperience in your position. I still do believe there could be a better method that is pretty low hanging fruit, however, I now understand why good enough and mathematically tractable is preferable to lower bias in the face of data, because for the most part in your use case, you are creating the data or there just isn't data available and everybody in that transaction is all good with that.

And, thanks to mr. Kevin's really interesting post, maybe what's important about the model is not the absolute price and it's weakness due to the IV flaw we've discussed, but what BS does do well is estimate greeks, in other words relative price. At the end of the day, you already have a market to price the asset, and what we really might need a model for is the greeks.

Anyways, thanks for humoring my aggressive half-truth Socratic questioning. I think I really get something I was not expecting to get.

Am I getting closer here? Shall we have a warm Hegelian moment? Or am I still missing stuff on the whole?

 

[smacdtrader]

dude you can make a point a really well, better than me, can i filter my messages through you?

We all know Newton's laws are just first order approximations to Einstein's laws of special and general relativity. But, I can still use Newton's laws to fly an airplane, guide a ballistic missile, control a satellite.... Unless I model the Universe, I don't need general relativity.

 

[schizo]

I now totally get what @taowave and @poopy are saying (even if poopy is a grumpy anger ball).

And I thought you were a fan of @destriero. Or maybe not.

 

[smacdtrader]

And I thought you were a fan of @destriero. Or maybe not.

undecided, he's clearly is choosing not to be helpful thus far

 

[smacdtrader]

I realize that this question is addressed to taowave, but allow me to address it.

BS, with the appropriate vol param, returns good (not just decent, but objectively good) greeks. You can look at the options exchanges as markets for greeks, rather than individual options. As another poster (mrmuppet?) has pointed out, single name chains are neither deep nor liquid at the individual contract level, but are often pretty deep and liquid viewed as a market for greeeks. And, for any option position, a certain greek exposure is what you're really after.

You can, of course, with considerable effort, create an arb free price surface, fit some smooth function in log-strike and root-time to it, and derive relevant model-free greeks via finite differences or some similar numerical method. You will get, to within a few decimal places, the BS greeks. This has always amazed me, and is something I use (or programs written by me use) every day.

Similarly I use BS greeks to derive implied terminal distributions under the risk-neutral measure Q. Again, you can derive model-free RND's using quantile maximum-likelihood methods on those same smoothed price surfaces, but it is much more onerous, and you'll end up with the same exact (to a close approximation) terminal distributions. You can integrate these RND's times the payout function to recover all the options prices model free (without BS -- the prices match BS almost perfectly). This near-perfect match between BS and model free implied distros is also something that amazes me, and is also something that I use on a daily basis.

In fact an options pricing model can be thought of as a method to recover prices under the risk neutral measure. With a few tweaks (strike-expiry specific vols, mainly), BS does an excellent job of that.

So do you find that garch or just some running estimate fixes the the flaws? Shouldn't it then actually find any mispricing pretty well, should it exist?

 

[taowave]

All is good...

There could be a "better" method/model,and as I mentioned.if you are trading the listed markets,with tight bid ask spreads,how is it going to help???

If your model estimates a vastly different value/greeks than Black Scholes,are you planning on delta hedging at your "hedge" vol to realise your forcasted theoretical edge?? Will you hedge at a vastly different Delta than what BS spits out???

I dont think so

ok. So while @ironchef definitely summed my point way better than I did. I now totally get what @taowave and @poopy are saying (even if poopy is a grumpy anger ball).

And indeed I was ignorant of the use case because of my inexperience in your position. I still do believe there could be a better method that is pretty low hanging fruit, however, I now understand why good enough and mathematically tractable is preferable to lower bias in the face of data, because for the most part in your use case, you are creating the data or there just isn't data available and everybody in that transaction is all good with that.

And, thanks to mr. Kevin's really interesting post, maybe what's important about the model is not the absolute price and it's weakness due to the IV flaw we've discussed, but what BS does do well is estimate greeks, in other words relative price. At the end of the day, you already have a market to price the asset, and what we really might need a model for is the greeks.

Anyways, thanks for humoring my aggressive half-truth Socratic questioning. I think I really get something I was not expecting to get.

Am I getting closer here? Shall we have a warm Hegelian moment? Or am I still missing stuff on the whole?

 

[poopy]

I've traded 00s of arbs with nothing more than BSM.

 

[taowave]

I was going to bring up Garch to illustrate that you are a bit confused...
Garch may help you come up with a better estimate of Vol,which you could plug into BS,but once again,then what???

You plug in a higher IV,options appear cheap and you delta hedge?? Its not a directional bet,you do realise that.. You are trading Vol,not direction

So do you find that garch or just some running estimate fixes the the flaws? Shouldn't it then actually find any mispricing pretty well, should it exist?