The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It

by Scott Patterson

Discovering how to price volatility was the key to unlocking the stock warrant treasure trove. Say you own a warrant for IBM. The current value of IBM’s stock is $100. The warrant, which expires in twelve months, will be valuable only if IBM is worth $110 at some point during that twelve-month period. If you can determine how volatile IBM’s stock is—how likely it is that it will hit $110 during that time period—you then know how much the warrant is worth. Thorp discovered that by plugging in the formula for Brownian motion, the random walk model, in addition to an extra variable for whether the stock itself tends to rise more or less than other stocks, he could know better than almost anyone else in the market what the IBM warrant was worth. Gamblers make such time-dependent bets all the time. The time to expiration of the warrant is similar to the four quarters of a football game, baseball’s nine innings, or a lap around the racetrack. Investors are wagering on a certain outcome within a predefined time frame. Thorp simply used his math skills and his well-honed gambling instincts to quantify the problem. But to the conservative crowd—think investors in Treasuries and blue chips—all of this seemed a sort of crystal ball divination of the future, an approach better left to hucksters and charlatans. A trained physicist such as Thorp, however, saw that it was simply a matter of assigning a certain probability to a future outcome based on fixed parameters—a practice physicist...