Option Fundamentals   • 9
developing and refining an option pricing model known as the Black-
Scholes or Black-Scholes-Merton model, which I will hereafter abbreviate 
as the BSM.
The BSM is a testament to human ingenuity and theoretical elegance, 
and even though new methods and refinements have been developed 
since its introduction, the underlying assumptions for new option pricing 
methods are the same as the BSM. In fact, throughout this book, when you 
see “BSM, ” think “any statistically based algorithm for determining option 
p r i c e s .”
The point of all this background information is that options are not 
only not new-fangled financial instruments but in fact have a long and 
proud history that is deeply intertwined with the development of modern 
economies themselves. Those of you interested in a much more thorough 
coverage of the history of options would do well to read the book, Against 
the Gods: The Remarkable History of Risk, by Peter Bernstein (New Y ork: 
Wiley, 1998).
Now that you have a good sense of what options are and how they are 
used in everyday life, let’s now turn to the single most important thing for a 
fundamental investor to appreciate about these financial instruments: their 
inherent ability to exploit directionality.
Directionality
The key takeaway from this section is evident from the title. In addition to 
demonstrating the directional power inherent in options, this section also 
introduces the graphic tools that I will use throughout the rest of this book 
to show the risk and reward inherent in any investment—whether it is an 
investment in a stock or an option.
For those of you who are not well versed in options yet, this is the 
section in which I explain most of the jargon that you simply cannot escape 
when transacting in options. However, even readers who are familiar with 
options should at least skim through this explanation. Doing so will likely 
increase your appreciation for the characteristics of options that make 
them such powerful investment tools and also will introduce you to this 
novel way of visualizing them.