Quote from asiaprop:
not sure whether you have actually said anything in this post.
Volatility cannot be reliably predicted, period. All you can do is build models that show relative mispricings in assets and trade one versus the others. Its far from arbitrate as a lot of direct and residual risks remain. History repeats itself but in ever changing lengths and velocity of cycles. Thats why there are very few proprietary pure vol traders who have scored big but a number of heavy hitting sell-side market making vol traders.
Not sure what benefit all that quant lingo serves, but I have market-made exotic rate derivs, market made swaptions, then later traded index and single stock vol prop, it always comes down to the same: On the market making side "know ya relative mispricings and flow", on the prop side "know the dynamics of the underlying in and out". I have not seen how any, no matter how sophisticated, french vol models ever guaranteed a dime trading vol on the prop side.
Valid points...
However, I believe that volatility expansion/contraction can be predictive (the second derivative). You may disagree - which is fair, but that is not to say it is not possible. I am certaintly not saying we can tell you if it is going up or down and by how much - we are looking at it as a measure of mass and the 3 derivatives or motion.
The point is - that an options price is a predictive implied value of the statical significance of the underlying. Simply put - the Straddle price is assuming an aprox 1 SD. That is predicitive - you either think it is undervalued or overvalued. Thus - one needs to be predicitive in their volatility assumption before buy/selling any premium.
As you point out mispricing is based on either the difference (which is usually the case) - as with Timberhill's market making model and most market making OR the other route is against a baseline propritary model (this has to be predictive by its very nature).
Market Makers act as a book maker - trading mispricing between the products. They move the line base on either order flow or expected flow - and their ability or inability to hedge that flow. Market Makers are (by their definition) not predictive in nature (just like a book maker). No Flow - No Money.
Market making has to assume mark price and thus volatility is already defined for the market maker - it is right there on the screen. They are just looking to capture the mis-pricing not to determine if it is high or low vs. the statical volatilty.
So for those that are not market making - one needs to make some level of predicition either delta and/or volatility. Any trade, by it's definition, assumes that prediction.
There are many flaws with the existing models, no doubt. Delta-neutral trading fails consistantly by the very nature of the model's short-falls. There are better models for better resolution - but they all work on the same principal.
Also - you either assume that stocks move in a random walk or you don't. I don't assume a normal distribution random walk - and that in itself can be a long winded argument - which I don't care to go down.
This is already a longwinded post and if you sat in our offices - these discussions go on for hours. I am certainly a realist - have traded for 20 years and made markets. I have made huge blunders and many mistakes. I certainly know the limitations of existing models - but that should not keep me from trying to push the envelope in approaching the problem differently.
I do enjoy picking the low-hanging fruit as you correctly pointed out, arbitrage and or mis-pricing cut/n/dry math trades. However, I do feel there is a missing link.
Simple reason -
Dice were used for over 200 years before people understood probability - think about how that changed the game.
It wasn't to long ago when market makers didn't understand the concept of skew or even simpler conv/rev arbitrage or boxes/jelly rolls.
Not saying that we will ever achieve our objective, but we will have fun trying - and who knows - it may reveal some other arbitrage opportunity that we didn't previously see.
Now I need to go check on that cat, he has been in the box a while. I think he is fine (wink wink).
