This segment discusses the “Efficient Market Hypothesis” and explains how it relates to options trading including the accuracy of the Black-Scholes model. This is the last show for tastytrade's math genius Jacob Perlman before he goes on sabbatical to finish his dissertation.
Jacob began by explaining the premise of the Efficient Market Hypothesis. The current price of a tradable asset is the correct price according to to the efficient market hypothesis. A trader expecting that the price would go up or down based upon some piece of information would trade on that information and the price would changed to match their effect on supply and demand.
There are a few versions of the Efficient Market Hypothesis that differ in how all encompassing the definition of “information” is, but all basically boil down to the fact that the only directional assumption that is reasonable to make about the movement of an underlying is the upward drift from the risk-free rate. At every moment the underlying may go up or down, and how that happens is fair.
Jacob further explained the random walk idea and how this is essentially a version of Brownian Motion. He then got to the heart of the matter. Assuming that everything is balanced and fair, and Black-Scholes is inevitably correct, how do we decide which trades to make?
There is only place to look to improve on Black-Scholes if you trust the Efficient Market Hypothesis, for trading purposes. Jacob reveals this at the end of the segment.
Watch this segment of “The Skinny on Options Math” with Tom Sosnoff, Tony Battista and tastytrade's Math Genius, Jacob Perlman for an in depth discussion of the Efficient Market Hypothesis and what we can learn from it to help our trading.