The Physics of Wall Street: a brief History of Predicting the Unpredictable

Tyranny of the Dragon King 
•
161
the strike price, you profit, because you have the right to buy the stock 
at the strike price, and then sell it at the higher market price, pocket-
ing the difference. of course, if the price doesn’t go up, that’s oK too. 
You’re only out the money spent on the option, and not the higher 
price of the stock itself. Put options work in essentially the opposite 
way. You buy the right to sell a stock at a specific price. In this case, 
you profit if the price of the stock falls below the strike price, because 
you can buy the stock at the market price and sell it at the higher strike 
price, again pocketing the difference.
recall that far-out-of-the-money options are options that will be 
valuable only if the market takes a dramatic swing. Since dramatic 
market swings tend to be unlikely, far-out-of-the-money options tend 
to be very inexpensive (because the people selling them believe they 
carry little risk). When markets crash, however, these far-out-of-the-
money put options can become very valuable indeed, with almost no 
initial cost. And if you know when the market is going to crash, you 
can walk away with enormous profits accrued over a very short time
— just a few days, say — with relatively little risk. It sure beats buy-and-
hold. the problem, of course, is predicting the unpredictable.
Imagine inflating a balloon. You start with a limp piece of rubber. In 
this uninflated state, the balloon is stretchy and very difficult to tear. 
You could poke it and prod it any way you like, even with a very sharp 
knife, and unless you stretch the balloon out first, the knife is unlikely 
to puncture it. A pin would do no damage at all. now begin to blow 
air into it. After a few puffs, the balloon starts to expand. the pressure 
from the air inside is pushing the walls of the balloon out, just enough 
to give the surface a roughly spherical shape. the material still has 
considerable give. depending on how much air has been pumped in, a 
very sharp knife might now slice the rubber, but the balloon certainly 
won’t pop, even if you manage to puncture it. A puncture would allow 
the air inside to leak, but it wouldn’t be very dramatic.
As you blow more air into the balloon, however, it becomes increas-
ingly sensitive to outside effects. A fully inflated balloon is liable to 
pop from the slightest brush with a tree branch or a bit of concrete — a 
tap from a pin is certain to make it explode. Indeed, if you keep blow-

---

ing air into a balloon, you can make it burst by touching it with your 
fingertips, or by simply blowing in another mouthful of air. once the 
balloon is primed, it doesn’t take much to produce a very dramatic ef-
fect: the balloon shreds into tiny pieces faster than the speed of sound.
What makes a balloon pop? In some sense, it’s an external cause: a 
tree branch or a pin, or perhaps the pressure from your fingers as you 
hold it. But these very same influences, under most circumstances, 
have little or no effect on the balloon. the balloon needs to be inflated, 
or even overinflated, for the external cause to take hold. Moreover, 
the particular external cause doesn’t much matter — it’s far more im-
portant that the balloon be highly inflated when it is pricked. In fact, 
the external cause of a popped balloon isn’t what makes the balloon 
pop at all. It’s the internal instability in the balloon’s state that makes it 
susceptible to an explosive pop.
the bursting of a balloon is one of a variety of phenomena known 
as ruptures. ruptures occur in all sorts of materials when they are put 
under stress. A rupture can often be thought of as a straw-that-broke-
the-camel’s-back effect: the stress on a substance, such as high internal 
pressure (caused, for instance, by the air in a balloon, or the gas in a 
soda can that has been shaken up — or the accumulated weight on a 
camel’s back), leads to instabilities that in turn make the material vul-
nerable to explosive events. these explosions, sometimes called criti-
cal events, are the ruptures. Just as when a balloon bursts, a rupturing 
material changes its state very rapidly, releasing a substantial amount 
of energy in the process. events that might otherwise have little effect, 
like a pin breaking the surface of an only partially inflated balloon, 
tend to cascade, building into something larger.
no one has done more to improve our understanding of ruptures 
than didier Sornette. He has been stunningly prolific. Still in his early 
fifties, he has published more than 450 scientific articles in just thirty 
years. He has also written four books, one on physics, two on finance, 
and one on Zipf’s law, the unusual distribution that first attracted 
Mandelbrot’s attention. But even more remarkable than the amount 
of work he has produced is its range. Most physicists, even the most 
successful, work in a handful of closely connected areas. Acquiring 
162 
•
t h e p h y s i c s o f wa l l s t r e e t

---