mula to price options. The Black-Scholes formulawas an instant success. It
gave traders a benchmark for valuation where previously they used
only their intuition. The formula was programmed on traders’ handheld
calculators and PCs around the world. Although there are conditions
when the formula must be modified, empirical research has shown that
the Black-Scholes formula closely approximates the price of traded op-
tions. Myron Scholes won the Nobel Prize in Economics in 1997 for his
discovery.^13
Buying Index Options
Options are actually more basic instruments than futures or ETFs. You
can replicate any future or ETF with options, but the reverse is not true.
Options offer the investor far more strategies than futures. Such strate-
gies can range from the very speculative to the extremely conservative.
Suppose you want to be protected against a decline in the market.
You can buy an index put, which increases in value as the market de-
clines. Of course, you have to pay a premium for this option, very much
like an insurance premium. If the market does not decline, you have for-
feited your premium. But if it does decline, the increase in the value of
your put has cushioned, if not completely offset, the decline in your
stock portfolio.
Another advantage of puts is that you can buy just the amount of
protection that you like. If you want to protect yourself against only a
total collapse in the market, you can buy a put that is way out-of-the-
money, in other words, a put whose strike price is far below that of the
current level of the index. This option pays off only if the market de-
clines precipitously. In addition, you can also buy puts with a strike
price above the current market, so the option retains some value even if
the market does not decline. Of course, these in-the-moneyputs are far
more expensive.
There are many recorded examples of fantastic gains in puts and
calls. But for every option that gains so spectacularly in value, there are
thousands of options that expire worthless. Some market professionals
estimate that 85 percent of individual investors who play the options
market lose money. Not only do options buyers have to be right about
266 PART 4 Stock Fluctuations in the Short Run
(^13) The original article was published in 1973: Fischer Black and Myron Scholes, “The Pricing of Op-
tions and Corporate Liabilities,” Journal of Political Economy, vol. 81, no. 3, pp. 637–654. Fischer Black
was deceased when the Nobel Prize was awarded in 1997. Myron Scholes shared the Nobel Prize
with William Sharpe and Bob Merton, the latter contributing to the discovery of the formula.