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Chapter 2
The black-scholes-
merTon model
As you can tell from Chapter 1, options are in fact simple financial instru-
ments that allow investors to split the financial exposure to a stock into upside 
and downside ranges and then allow investors to gain or accept that expo-
sure with great flexibility. Although the concept of an option is simple, trying 
to figure out what a fair price is for an option’s range of exposure is trickier. The 
first part of this chapter details how options are priced according to the Black-
Scholes-Merton model (BSM)—the mathematical option pricing model  
mentioned in Chapter 1—and how these prices predict future stock prices.
Many facets of the BSM have been identified by the market at large 
as incorrect, and you will see in Part III of this book that when the rubber 
of theory meets the road of practice, it is the rubber of theory that gets 
deformed. The second half of this chapter gives a step-by-step refutation 
to the principles underlying the BSM. Intelligent investors should be very, 
very happy that the BSM is such a poor tool for pricing options and pre-
dicting future stock prices. It is the BSM’s shortcomings and the general 
market’s unwillingness or inability to spot its structural deficiencies that 
allow us the opportunity to increase our wealth.
Most books that discuss option pricing models require the reader to have 
a high level of mathematical sophistication. I have interviewed candidates with 
master’s degrees in financial engineering who indeed had a very high level 
of mathematical competence and sophistication yet could not translate that 
sophistication into the simple images that you will see over the next few pages.