Famous Formulas, Fame and Fortune

Demetri Papacostas and Francesco Tonin

Having grasped basic option terminology and the straightforward way we can calculate option value at expiration, we are ready to start exploring option valuations before expiration. This topic is key because calculating option values at any point in time before expiration allows us to understand what constitutes a fair price, and opens a window into the FX market’s mind. What does the market expect to happen in the future, how has it reacted in the past, what levels are important to watch and on what dates?

In the next couple of chapters, we begin our trek to discover the most celebrated formula in all of finance, the Black–Scholes formula. This formula was discovered and applied in the early 1970s by Fischer Black and Myron Scholes, whose work in turn was based on previous studies by, among others, Edward O. Thorp. Thorp tried to make money out of being one of only three people on the planet to know the correct price of options, and went on to become very successful operating a hedge fund. Black and Scholes also attempted to make money but failed, and so in 1973 they capitulated and accepted academic fame instead by way of publishing the formula to the entire world (Poundstone