Theory vs. reality. The Black-Scholes black hole

The Black-Sholes option pricing model and the theory of portfolio insurance that emerged from it has been widely used on Wall Street as a way to do riskless investing because one would always be hedged by shorting the S&P.

Good theory. The glitch was discovered only after the fact: When a market is crashing and no one is willing to buy, it’s impossible to sell short. If too many investors are trying to unload stocks as a market falls, they create the very disaster they are seeking to avoid.

The theory doesn’t allow for massive price shifts or for the inability to find buyers. So, when it needs to work the most reliably is precisely when it doesn’t.

The very theory underlying all insurance against financial panic falls apart in the face of an actual panic.

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