Time to go vega positive?

[MDCigan]

Quote from TempusFugit:



Thanks for the reply. I'm always looking for pushback to my idiosyncratic views.

Efficiency does not mean "not-mis-priced" the way I'm using the term. Rather it means that typical investors, on average, will not beat the market.

OK, but that is not typically the accepted definition of what an "efficient" market is. I completely agree with the conclusion that on average the typical investor will not beat the market. I also believe the typical Sunday Joe B-Ball player is not going to beat Michael Jordan, Lebron James, a college starter, or even a star high school player for that matter. That simply is a reflection of the skill of the average participant and totally irrelevant to the question of whether pricing is efficient.

The average market participant (even some pros for that matter) have not mastered control of their own emotions and psychology and therefore will tend to be those who buy high and sell low, as opposed to those who use the alternatives of buy high and sell higher, or buy low and sell high of which I think both are valid. As a result, they are doomed to underperform.

Efficient pricing as the term is used means all information is factored into the current stock price, and that no fundamental analysis, valuation analysis, or technical analysis increases the statistical probability of stock price movement in a particular direction. All current and future information is already in the price and future price movement is purely random and will react to future news which is inherently knowable. There is no such thing as "statistical edge". Frankly, I think that is the biggest pile of horsesh*t there is, and there is actually plenty of evidence to refute that but the efficient market disciples have control over academia.

There is a quite demonstrable and proven value effect to stock prices over long periods of times. Stocks with low P/E, low P/S, and low P/B ratios outperform over long periods of time. There is solid evidence for this. Relative strength and the momentum effect also have a strong body of evidence to support them over a more shorter to intermediate time frame such as 6 months to a year. There is also quite strong evidence coming from the emerging behavioral finance field about human psychological tendencies creating persistent mispricings. Overreaction to bad news and underreaction to good news create some of the inefficiencies mentioned above. Essentially, the above state that over shorter time frames stock prices trend, and over long time frames they mean revert which to me seems quite obvious when you look at multi-year charts.

On the technical side, I believe many technical indicators and analysis work because they are essentially self-fulfilling prophecies. If enough traders believe the 50 day EMA is support, well then, it will be support because they will all be stepping in to buy at that price level. There was also a recent thread somewhere on ET where a study done at MIT was referenced that showed certain price patterns do indeed have positive predictive capacity.

Let's take as a representative body of typical investors....how about mutual fund managers? I bet you will agree that they did not out perform the market (proxy = SPX) during the 1999-00 period you reference. Indeed, I believe the data show they tracked the market, or trailed it slightly, on average. So the market was efficient, but in retrospect clearly wrong. So far, we've just taken the proverbial random walk down wall street.

Actually, I don't agree, and it is because you are oversimplifiying here greatly. First off, you have to do an apples to apples comparison. The SPX is NOT a proxy for the market. It is a proxy for large cap stocks, and really large cap growth at that because it is market cap weighted. You can't compare a small cap value manager to the SPX. Having said that, there is actually strong evidence that many if not most managers outperform their respective indexes and have actual stock picking skill. In small cap, mid cap, and ESPECIALLY international active managers tend to consisently beat their respective indexes. The same does not exist in large cap world but I would submit that most managers running large cap funds are closet indexers. Trust me on that. I know this to be true. You can't beat the index if essentially you've committed yourself to mimicking it minus a few meaningless tweaks here and there. Pull up the 5 largest by AUM large cap funds and compare the holdings to the S&P 500.

One last point, I don't have the reference for the study handy but I'll dig it up if you want me to, but there was a detailed academic study (I think Werner is the author) that showed the average manager's stock picks outperformed but it was the expense ratio of the fund that caused the underperformance relative to the benchmark.

With respect to volatility, the point is not that it is mis-priced but that there is room for options sellers to net positive because options buyers are willing to net negative as they buy their insurance. There is a service component built into the notion of an option -- an exchange of value for risk assumption -- that doesn't exist in a straight equity trade. Equity zero sum; options positive sum.

I must admit I am thoroughly confused by what you are saying here. Typically, options are referred to as a zero sum game. There is ZERO real wealth creation with options. There is no net wealth created. Equities on the other hand are a positive sum game because historically equity prices trend up and represent actual cash flows and dividends of their underlying companies.

I don't believe there is any accuracy to your statement about option sellers being net positive or option buyers being net negative. Either option selling or buying can be delta hedged and there is no reason to believe an inherent premium exists that goes to the option seller. Particular strikes such as OTM puts on OEX may have this characteristic but it would not be universal. With IV levels at current multi-year lows would you argue that option sellers are getting a risk premium for writing options.

Any comment on my first point -- that being long or short vol is not always a directional punt?

I would agree. I spent some time the other day looking at stocks with huge short interests and what happened to IV as they gapped up during an apparent short squeeze and/or stocks making parabolic moves up. IV typically increased during these episodes so it definitely seems possible for IV to increase with positive stock price movement.

 

[TempusFugit]

Quote from MDCigan:



I would agree. I spent some time the other day looking at stocks with huge short interests and what happened to IV as they gapped up during an apparent short squeeze and/or stocks making parabolic moves up. IV typically increased during these episodes so it definitely seems possible for IV to increase with positive stock price movement.

I very much appreciate your thoughtful (and thought provoking reply).

With respect to efficient markets: all the original hypothesis claimed was that the typical investor (using TA, FA, voodoo, whatever) can't beat the market. It later got elaborated into the Efficient Market Theory with all the stuff about "all information is factored into the current stock price" etc. One doesn't need to believe the latter to believe that the former is true.

With respect to market proxies, true, SPX proxies the market for big caps only. I used it because it does represent the major portion of US market cap. It also tends to exhibit market efficiency to a high degree: "the average manager's stock picks outperformed but it was the expense ratio of the fund that caused the underperformance relative to the benchmark" translates for me: "couldn't beat the market net of expenses."

Small cap is the one area where I believe FA may actually yield an edge for professionals who have the time, resources, access and good judgment to find the diamonds in the rough. But in doing so, they profit by taking inefficiencies out of the market and over time I expect this source of abnormally good profits to be competed away. Strictly speaking markets are not effcient in some ideal sense; they become ever more efficient as progress marches on.

Finally, as you correctly point out, equites are a positive sum game; my point is that trying to do better than the market (i.e., move beyond your share of the positive sum) is a zero sum game in an efficient market.

I'll admit to being confused by me too, because I am struggling to justify to myself how as a little fish I can expect success in the options market when as an efficient-market fundamentalist I believe I cannot expect success (beyond market returns) in the equities market.

So please let me withdraw my comments about efficiency with respect to options and just say this: It seems to me that options do create utility (a non-pecuniary wealth, if you will) for those who purchase them as insurance.

The positive sum received in exhange for this service is then re-distributed amongst options traders and it is certainly the case that the eventual winners include those who have been long, short and neutral. My hypothesis is just that if we were to add up all the profit and losses of all the traders, the sum would be positive.

My goal is to regularly harvest a small sliver of the positive sum so that I can pay the bills and never get a W2 again.

 

[quantpatterns]

Quote from Maverick74:


So if you are trading options over a long time period you cannot be at the mercy of any so-called quant and the perceived edge he thinks he has. So I say again, don't mind the guys upstairs, they have absolutely no effect on your trading to speak of. The only edge that you need in options trading is for the market to move and to be open. Then your in business.

Maverick,

I think you nailed it on the head. Being an ex-quant myself, I can tell you the so called "statistical arbitrage" edge is actually very thin. In Treasury markets, some banks might put on $50M to make a few hundred thousands over a few days. That's how small the edge is. But since these players have almost unlimited capital(or at least they think they do through line of credit. haha.) they can continue to play these small edges and make a lot of money, until one day....

Long term forecast is just as hard for anybody. When you are doing long term forecast of stocks, options, bonds, etc. you are actually competing with money managers who manage in the hundreds of billions in aggregate and their views. And if these long term buyer/sellers decide on the same opinion then strong trends will persist! That's why sometimes a lot of quants get "squeezed" by fundamental buyers when things don't mean revert! If the market trends one way or the other, some quants get killed. Smarter quants incorporate more things in their models than just mean reversion. Don't think that quants have all the answers..

 

[Maverick74]

Quote from quantpatterns:



Maverick,

I think you nailed it on the head. Being an ex-quant myself, I can tell you the so called "statistical arbitrage" edge is actually very thin. In Treasury markets, some banks might put on $50M to make a few hundred thousands over a few days. That's how small the edge is. But since these players have almost unlimited capital(or at least they think they do through line of credit. haha.) they can continue to play these small edges and make a lot of money, until one day....

Long term forecast is just as hard for anybody. When you are doing long term forecast of stocks, options, bonds, etc. you are actually competing with money managers who manage in the hundreds of billions in aggregate and their views. And if these long term buyer/sellers decide on the same opinion then strong trends will persist! That's why sometimes a lot of quants get "squeezed" by fundamental buyers when things don't mean revert! If the market trends one way or the other, some quants get killed. Smarter quants incorporate more things in their models than just mean reversion. Don't think that quants have all the answers..

Well, here is another way to look at it. LTCM, who arguably had the smartest quants in the world, created an edge that yielded them somewhere close to .05% to less then 1% a year. That's right, if they were fully invested, these geniuses would have managed less then 1% return a year on their money. It was only with massive leverage that they were able to earn impressive returns. Leverage which in some cases was illegal due to the corrupt financing of many of their trades.

So if the traders on this forum don't have access to that kind of insane leverage, you would be lucky to earn a few percent a year on this statistical arbitrage. Just look at how some of the best stat arb hedge funds have done this year, very poor performance. And these are some of the brightest minds in the game.

I've said it a million times on this board but I might as well say it again, I'll take a trader with intuition, instincts and solid risk management skills over a quant any day.

And I'll say this again as well, with options, there is so much money to be made with the latter skills I just mentioned.

 

[sle]

Like I said before, quants on option trading desks generally create models that allow traders to hedge portfolios more effectively or create arbitrage opportunities through synthetic opportunities.

Yep. There is no way to live without a view on the market, quantitative or non-quantitative. The only other way is to f*** the other guy by selling him something that he is not clear about (see numerous examples like in arrears swaps (a big firm starting with G) and many others).

Well, it is almost impossible with any degree of certainty to predict long term volatility. Hell, its almost impossible to predict short term volatility.

Well, come on, you have to complete this one: "Hell, its almost impossible to predict anything" But you can take a directional view and stick with it. For example, a good directional view right now would be that the yield curve will flatten, probably in a bullish manner. Taking a view on vol is no different - for example, recently I have spoken to a guy that thought that LIBOR swaption vols will steepen, and they did exacly the opposite about a month ago... too close to the bonus time, bummer.

 

[sle]

I think I have to post this here to end this discussion:

I have come to New York with a PhD from ********. Quickly, I answered an internet ad by a chasseur de tête who sent me to a foreign bank. Two interviews and I aced them all. A week later, I'm on the desk. "Dude, you are getting a Dell!" I say to myself.

With my scientific PhD, I find option theory easy as p. I have studied heat conduction and quantum mechanics so I quickly comprehend the options: a is intercept, b slope, G curvature, D tangent, s temperature, q sensitivity, m drift. If I know derivatives, I know Derivatives. Soon I am an expert at Black-Scholes and Beyond. Yield curves are strings. Feynman to me? Kaç to you! Everything's an option. I am one dynamic hedger, man.

On the prop desk my boss is Alden, an MBA, and I'm his quantitative guy. He calls me a geek; he knows no math but he sure knows business; he can use the same word as noun, adjective, exclamation and gerund in single sentence when he's angry. Alden's risque assistant is Lidia, a truly exotic option, a total knock-out with a non-normal distribution which makes the option salesman whistle and mutter softly about barrier penetration.

I have rational expectations for Lidia but I feel she don't respect me. She like old movies but has no taste for mathematics and its beauty. To her I am far out-of-the-money.
Now the bank wants to do structured products. I have Excel, I buy VBA, I get models from optionmodels.com and now I'm in business. We're doing long-term puts and calls, down-and-outs, converts, one-touches, spread options, CDS, vol swaptions, whatever, and I'm getting all the prices. I find model for anything. Easy as Dell. Once a week we run my spreadsheet to mark the book. Big P&L fast. Then late dinner with Alden at Bouley or Jean-Georges.

But always Lidia's on my mind. When I watch her wandering across the floor, I cannot but think of excess kurtosis. I try to cliquet with her for coffee but she DK my trade. I sense there is little chance of a transformation between her p-measure and my q-measure.

One day someone offers Alden a big position in spread option barrier reversal American no-touch interest rate euro swaptions, denominated in Turkish lira. According to my model, these Sobranies are pretty cheap. Lots of a, high k, big Sharpe. Alden take $100 million face for the desk and his boss bought some for his own PA too.

Next day the broker offered us much more at the same price ? great deal! Each day's close I tell Alden how my model says to re-hedge the Eurodollar futures and the lira, and then we execute. Except I am always thinking sadly about Lidia, dreaming of her capital assets. Will I ever know her efficient frontier?

Next week comes by the head of model risk, ENS graduate Dr Jean-Martin Geille, an expert in Malliavin calculus. And Vlad, chief risk modeller.

"You're VAR is way up, mon ami," said J-M to Alden, very loud. "What model 'ave you used for the Sobranies?"

My model is one-factor Monte Carlo with control variate, $125 from the web. Vlad's is three-factor Crank-Nicolson PDE with fat tails and LU decomposition, he tells me, written in Java on his Linux laptop. His say we have a lot less a than mine.

"You pay too much m for too little k!" say Vlad.

"What's it all about, a?" Lidia sings in her deep voice. She cannot understand the situation is serious.

But J-M does. "I am arrestin' you for ze future mis-markin' of complex instruments," he yells, waving his hands as he jumps in front of Alden. He joke, but Alden doesn't laugh. He knows J-M would do anything to make risk department look good. We are e away from big trouble.

That night the risk committee uses Vlad's model. Their report shows big drop in our marks. "No-one knows what this is really worth," moans Alden. "We'd better unwind and cut our losses. No Zermatt this Xmas ..." Bonus day is only a month away.

So much volatility is difficult to concentrate... At the close I execute the end-of-day Eurodollar hedge and leave lira rebalancing for next morning.

When I get to work Alden is popping.

"Did you hedge last night?" he yell.

"Eurodollars yes, lira no!" I say.

"Great!" shout Alden. "Trouble in the Middle East ? 7 percentage point drop in the Turkish lira overnight. The Sobranies knocked in. How'd you guess?"

"I been learning extreme value theory," I tell Alden.

"Good call, guy!" he say as he squeeze my shoulder.

The Sobranies triple and we close out. I make 20 units for the desk. Lidia looks at me with new respect. On bonus day I invite her to dinner at Jean-Georges.

"How did you do it?" she smile at me over the Petrus '85.
I can see our implied correlation is approaching unity and I am ready to early exercise.

 

[quantpatterns]

Quote from Maverick74:



Well, here is another way to look at it. LTCM, who arguably had the smartest quants in the world, created an edge that yielded them somewhere close to .05% to less then 1% a year. That's right, if they were fully invested, these geniuses would have managed less then 1% return a year on their money. It was only with massive leverage that they were able to earn impressive returns. Leverage which in some cases was illegal due to the corrupt financing of many of their trades.

So if the traders on this forum don't have access to that kind of insane leverage, you would be lucky to earn a few percent a year on this statistical arbitrage. Just look at how some of the best stat arb hedge funds have done this year, very poor performance. And these are some of the brightest minds in the game.

I've said it a million times on this board but I might as well say it again, I'll take a trader with intuition, instincts and solid risk management skills over a quant any day.

And I'll say this again as well, with options, there is so much money to be made with the latter skills I just mentioned.

Maverick,

However, given what I said which is somewhat of slight mark against quants, now I'll give a counterargument supporting them. Just to see two sides of the coin. Remember, quants are trying to do "risk free arbitrage". If they put on $100M or $1B trade to earn 1% risk free, then they will do it. And do it over and over and over again. But to find those perfectly hedged small window of opportunities where you move $1B and earn 1% risk free requires some serious statistical and quantitative research.

But what most quants forget after a while is that there's NOTHING, I repeat NOTHING that is truly risk free! Even T-bills have risk since inflation can eat into your real returns. And rising rates will make t-bills go down if you are forced to sell it.

Most traders on this board are taking trades that are not risk-free. But it's OK. You have to take risk in order to earn excess returns in the markets. The so called risk free arbitrages where free money is laying around to pick is an illusion...

 

[quantpatterns]

Quote from sle:

I think I have to post this here to end this discussion:

I have come to New York with a PhD from ********. Quickly, I answered an internet ad by a chasseur de tête who sent me to a foreign bank. Two interviews and I aced them all. A week later, I'm on the desk. "Dude, you are getting a Dell!" I say to myself.

With my scientific PhD, I find option theory easy as p. I have studied heat conduction and quantum mechanics so I quickly comprehend the options: a is intercept, b slope, G curvature, D tangent, s temperature, q sensitivity, m drift. If I know derivatives, I know Derivatives. Soon I am an expert at Black-Scholes and Beyond. Yield curves are strings. Feynman to me? Kaç to you! Everything's an option. I am one dynamic hedger, man.

On the prop desk my boss is Alden, an MBA, and I'm his quantitative guy. He calls me a geek; he knows no math but he sure knows business; he can use the same word as noun, adjective, exclamation and gerund in single sentence when he's angry. Alden's risque assistant is Lidia, a truly exotic option, a total knock-out with a non-normal distribution which makes the option salesman whistle and mutter softly about barrier penetration.

I have rational expectations for Lidia but I feel she don't respect me. She like old movies but has no taste for mathematics and its beauty. To her I am far out-of-the-money.
Now the bank wants to do structured products. I have Excel, I buy VBA, I get models from optionmodels.com and now I'm in business. We're doing long-term puts and calls, down-and-outs, converts, one-touches, spread options, CDS, vol swaptions, whatever, and I'm getting all the prices. I find model for anything. Easy as Dell. Once a week we run my spreadsheet to mark the book. Big P&L fast. Then late dinner with Alden at Bouley or Jean-Georges.

But always Lidia's on my mind. When I watch her wandering across the floor, I cannot but think of excess kurtosis. I try to cliquet with her for coffee but she DK my trade. I sense there is little chance of a transformation between her p-measure and my q-measure.

One day someone offers Alden a big position in spread option barrier reversal American no-touch interest rate euro swaptions, denominated in Turkish lira. According to my model, these Sobranies are pretty cheap. Lots of a, high k, big Sharpe. Alden take $100 million face for the desk and his boss bought some for his own PA too.

Next day the broker offered us much more at the same price ? great deal! Each day's close I tell Alden how my model says to re-hedge the Eurodollar futures and the lira, and then we execute. Except I am always thinking sadly about Lidia, dreaming of her capital assets. Will I ever know her efficient frontier?

Next week comes by the head of model risk, ENS graduate Dr Jean-Martin Geille, an expert in Malliavin calculus. And Vlad, chief risk modeller.

"You're VAR is way up, mon ami," said J-M to Alden, very loud. "What model 'ave you used for the Sobranies?"

My model is one-factor Monte Carlo with control variate, $125 from the web. Vlad's is three-factor Crank-Nicolson PDE with fat tails and LU decomposition, he tells me, written in Java on his Linux laptop. His say we have a lot less a than mine.

"You pay too much m for too little k!" say Vlad.

"What's it all about, a?" Lidia sings in her deep voice. She cannot understand the situation is serious.

But J-M does. "I am arrestin' you for ze future mis-markin' of complex instruments," he yells, waving his hands as he jumps in front of Alden. He joke, but Alden doesn't laugh. He knows J-M would do anything to make risk department look good. We are e away from big trouble.

That night the risk committee uses Vlad's model. Their report shows big drop in our marks. "No-one knows what this is really worth," moans Alden. "We'd better unwind and cut our losses. No Zermatt this Xmas ..." Bonus day is only a month away.

So much volatility is difficult to concentrate... At the close I execute the end-of-day Eurodollar hedge and leave lira rebalancing for next morning.

When I get to work Alden is popping.

"Did you hedge last night?" he yell.

"Eurodollars yes, lira no!" I say.

"Great!" shout Alden. "Trouble in the Middle East ? 7 percentage point drop in the Turkish lira overnight. The Sobranies knocked in. How'd you guess?"

"I been learning extreme value theory," I tell Alden.

"Good call, guy!" he say as he squeeze my shoulder.

The Sobranies triple and we close out. I make 20 units for the desk. Lidia looks at me with new respect. On bonus day I invite her to dinner at Jean-Georges.

"How did you do it?" she smile at me over the Petrus '85.
I can see our implied correlation is approaching unity and I am ready to early exercise.

sle,

GREAT POST!! I LAUGH SO HARD AT MY DESK!!!

ROFL!!

 

[NUTSNEAL]

I have to agree!!!


That may be about the best post I have ever seen on ET.

Thanks A Lot

I am still laughing so hard I can hardly type!

 

[NUTSNEAL]

In answer to your comments about the MARKET, I must say if you can not figure out how to take some SERIOUS money out of something this pretty (see attachment), I suggest you practice and practice and practice the phrase, "Would you like fries with that?"

Good Luck