How Do Options Make Predictions?

[short&naked]

Quote from MAESTRO:

Again, an excellent question! Yes, an individual behavior could potentially be quite deceptive. However, synchronized change in premiums of a long chain of options is immune to it; the same way one idiot (could be even a president) is not an indication of an entire nation’s intellectual level.

Lol, in the U.S. it is!

 

[short&naked]

It is interesting that regardless of the approach taken, most edges are seeking levels of capitualtion which in turn reveal extremes of supply and demand.

A great example was given by the Rydex cash flow ratio in 2002/03 when the last bull capitulated, leading into the next bull market:

 

[jem]

Quote from MAESTRO:

I have always thought that the technical analysis is limited to the price/time/volume relationship. If you consider building mathematical models of human behavior using other than the price/time inputs being a part of technical analysis then there is no argument. However, there is a big fundamental difference between traditional TA and cybernetic models. They use way higher number of uncorrelated inputs and have strong feedback loops that constantly adopt them to real time conditions. The reason why “setups” always have limited life is because their complexity is usually less than the complexity of the environment they live in (Ashby’s requisite verity principle). It makes them unstable and very limited. Option chains give the needed complexity that none of the traditional TA could possibly give simply because they have magnitudes higher variety. Also, there is no “scanning” involved in my methods. I use singular models for singular securities. My criticism of traditional TA has been always directed to the fact of its severe limitations. In other words, it is very difficult to make sense of what is going in the room by just peeking through a key hole. Fibonacci levels are also conventionally used in a very primitive, literal way therefore they are not better in this respect than any other line drawn on the chart. But, if you use them as a natural gravity centers you will realize that the distribution of the prices around them is different than around any other line. Fibonacci ratios exist in option chains as well, but they cannot be literally used. Seeds of the sunflower are always arranged in the Fibonacci spiral pattern yet no one can predict where the particular seed will appear. General population has severe limitations in understanding of probabilities models thus constantly demanding clear causality to feel better about them selves. Humans always look for patterns in the places where they do not exist and miss the obvious patterns because they treat them literally. Oh, well.

The lines I draw create bounces far more often than random lines.

In fact in the 90s I owned a website called careerdaytrader.com. I told traders to look at the points we posted as having gravity.

Then we looked for an reason to believe our trades were either going towards or pulling away from our black holes.

The method was very profitable for many of the traders in our llc.

It always amazes me when people say t/a does not work. It works great in markets without tons of noise. I will let others to figure out noise is.

 

[ej420]

I played around at one point in the past with using the risk-neutral distribution for the underlying price implied by the current options premiums (the entire chains puts/calls etc.) I think I need to revisit that line of research, as at the time I was a little limited by the data I had. The idea is basically that, with some math expertise, you can take all option premiums and with very mild assumptions (no black scholes or anything) figure out what the market expects of the underlying. I have not properly tested the edge of this in trading, but currently that distribution implies that the most likelye closing of SPY at Feb expiration should be in the 89-91 range.

 

[Sniemiec]

Quote from MAESTRO:

This is a Prop-Trading part of our business.

http://www.marketguidance.com/index.html

It is a separate operation from our Money Management division. The "multi-monitor" setups are used for all of our 3 divisions. We currently have operations in 4 different cities. The trading floors are different for all of them. I just want to make something very clear:

Located in Ontario. Are you Canadian, Maestro?

Quote from MAESTRO:

Watch this:

http://www.ted.com:80/index.php/talks/steven_strogatz_on_sync.html

Very cool!

 

[MAESTRO]

Quote from Sniemiec:

Located in Ontario. Are you Canadian, Maestro?

I am.

 

[thstart]

>Thanks for the wonderful insights >Maestro.

>http://www2.warwick.ac.uk/newsandev...starlings_help/

Here is the pdf link of this paper:
http://arxiv.org/PS_cache/physics/pdf/0612/0612198v2.pdf

 

[SmithTheTrader]

Quote from stock777:

mte's answer is close enough. The added genius is debatable.

Essentially , the atm straddle tells you what the market thinks the breakeven move will be , so that neither buyers or sellers have an apparent 'edge'. If you think they are mistaken then you can play happily. If not, you can't. They get it wrong often enough.

The problem is even they get it wrong most of the time, , e.g. the market move less or more than the "predicted" breakeven, you still can't make money out of it as you don't know you should long or short straddle in each time

 

[riskfreetrading]

Quote from MTE:

OK, OK, here's the answer:

Look at the price of the ATM front month straddle (assuming the move is expected before the front month expiration), which is the approximate size of the move that the market expects.

You are absolutely wrong!

The expected move is ZERO!

But if you mean in your mind that the move is a standard deviation from current price in one of the direction, then you are also wrong, as you are missing a 50%: One standard deviation is almost equal (but a bit less) than 150% the price of the straddle. Run it on a calculator, and you should be able to assess the numbers.

PS: for all my friends here, I say hello. I have been absent from disussions/visit/reading, so I wan to say hello.

 

[riskfreetrading]

Quote from nitro:

Well, this is not incorrect, but it is incomplete.

The theta of the straddle can also be covered if the realized volatility is such that the underlying moves back and forth enough to cover theta. So if a stock is $5 say, and the ATM straddle is $1, that does not mean the market expects the stock to be $4 or $6 within the given time to expiration of the straddle. However, that would be one way that the the straddle theta would break even.

the above post is similar to a poet giving a mathematical proof: it sounds right, but it is wrong in substance, and what matters. The market must be forgiving since characters such as Nitro are making money even if most of what they have in their heads is the opposite of what is right.