Paul: a Perfect Example

A very good common sense approach.Stock brokers tell you not to short stocks because you have unlimited risk vs limited gains. How foolish.

... I can't believe how well you've taken eLROY's badgering.


Contrary to what he implies, there's no need to feel like a moron for getting some figures wrong in a quick note to this forum, especially if you're willing to go to the trouble of setting things straight, as you've been doing.


I'm still worried that the numbers on this trade don't look right. The one year volatility of the 30-year must be greater than 10% (I'm guessing it's around 15%), so the one quarter volatility must be greater than 5%. This means that, assuming you made your trade at least three months before expiration, 113 is less than one standard deviation away. Assuming a gaussian random walk (which is conservative, since the real distribution has long tails), I estimate that the expected return on your position is below -10 ticks (including your 15 tick credit) ... perhaps well below.

I did the trade with less than 10 weeks left.

Long and wrong! Oh but you probably bought the uptrend into January of 2000.Still waiting to get even?

If you are asking whether you can exercise early

or be assigned early the answer is yes.

Dr. Bill,


I called the high on the morning of Thursday, March 30, 2000 - 4 days off the Nasdaq 100 high, and the week before the meltdown began. How did I do it?


During the bull market, I became an expert on the psychology of pullbacks. Specifically, beginning during what I call "The '96 Payroll-Number Era" (beginning the first Friday in March of 1996, and climacing on July 16, 1996), I began toying with a strategy that, more or less, went


1) buy first pull back,

2) buy second pullback,

3) scalp or sit out third pullback,

4) sell short fourth pullback,

5) keep selling short pullbacks until you get a washout, and

6) start buying pullbacks again.


Looking at how the S&P's reacted to the stunning job growth - in a period when interest-rate action from the 1980's was still remembered clearly and the S&P's tracked the bond all day - you will see that following the first Friday of each month starting in March of 1996, the futures behaved perfectly so as to frustrate anyone who had "learned" how the Non-Farm Payrolls event resolved itself in the previous month.


(The system traders in the bond were also massaged into a 5-day cycle which fed back into this Friday-report phenomenon. To see what I mean, run an algorithm over the last 20 years that buys or sells bonds when the 5-day close-to-close rate of change is greater than the 10-plus-1-day average 1-day close-to-close rate of change times 2.6.)


In April and May of 1987, people had also clearly learned to buy the pullback. And in June and July of 1987 the pullbacks failed utterly. As such, it was a fair bet that people were loading up into the September 1987 pullbacks - meaning there was enough underlying selling going on for there to be pullbacks even though they were camouflaged by short-term buying.


Then when, in the beginning of October, 1987, the market failed right before actually paying off those who had bought the pullback - failed at the moment they actually tried to take their profits - and instead dipped back down for a third helping of buyers - you knew it was the doom scenario. (Visit channelingstocks.com for an illustrative example of the idiocy.)


So, I saw the same chart thing setting up in the Spring of 2000. If they hadn't learned to buy the pullback before, they certainly learned to buy it in the the tax-loss and other selling during January 2000. The big-washout buyers had gotten paid in The '97 Needle and the '98 Washout. In '99, they had waited all Fall for a real buying opportunity to lock in, but there were too many chasing it for it to happen.


So it set up perfectly, just like 1987. On 3/16 and 3/21 2000, the fast-money/Yahoo crowd were clearly buying the Nasdaq pullbacks for a new high. And yet is was pulling back anyway. Then, it crept up towards a new high, but instead of making one, it pulled back for a third dip of buyers. How could it still have an appetite for more unless there was camouflaged selling? So on that morning I called short, though unfortunately, I still saw the market in S&P-futures terms, and the idea of selling the Nasdaq 100's never occurred to me!?


Then the first nasty day came the next week, when the people who had taken the third dip got overwhelmed and washed out. But at the day's low, I called the reverse, because I knew - having "learned" from 1997 - this is where the second wave of longer-term suckers would dig really deep into their pocketbooks and make a final stand. It reversed off the dizzying lows famously.


But I predicted an even worse washout as soon as this crowd tried to sell back down to the sleeping level - or the moment the market crept towards their margins, coming soon and time-structured around the days of the week, regular-way settlement, or whatever. All the buyers were spent for the time being. Then the washout came and, at the close on Doom Friday, when everybody was scared, I predicted Monday would be a non-event.


Just in time on Sunday, I came across a San Francisco Examiner article that confirmed my entire hypothesis:


http://www.sfgate.com/cgi-bin/articl...EDITORIAL1.dtl


It wasn't until maybe May 2000 that I got REALLY long-term bearish. And it wasn't until I really sat down face-to-face with people on Wall Street and Sand Hill Road, and really got inside their heads about a year ago - in the Nasdaq 2850 area, that I stretched my expectations the whole way down to Nasdaq 900 or something (I don't remember exactly).


Of course, I did call the low after 9/11 to the day, just like I called the '98 low to the day and on that day named the ten highest-flying blue chips of subsequent period (not Nasdaq yet-unknowns) almost to the stock! I also called the early '96 low to the day, and the '97 Needle low to the half hour.


Am I a billionaire? Not a chance. There are a lot of ways for a someone to screw up, even if he can predict the stock market. You might even say "especially if he can predict the stock market." Anyway, you really should read that article, so I'll post it again, and it is also a lot of fun to go back and read 1987 papers, which I have done quite a bit of.


http://www.sfgate.com/cgi-bin/articl...EDITORIAL1.dtl


eLROY

If you have a knack for picking lows in the stock market or in individual stocks you should be

doing "fences" in the options.The stock market is

the only(except on rare occaisons) that pays you to go long.I would love to hear an explanation for the skew in the stock market and stock options if you have one.I am referring to the fact that puts that are equidistant from the money as the same calls trade at a huge premium.

I have never heard a satisfactory answer for this.

There are two reasons why equi-distant puts and calls trade at different prices. One is known as put-call parity, and is based on interest rates, and the other is an asymmetry based on the nature of an investment. I mention the first just to make sure people know what the heck we are talking about when we say equi-distant!


Futures trade at a premium to cash, because you can construct a synthetic risk-free bond by buying the cash today, and locking in a future sale at a future price by selling the future today. If this were not so, you could sell short stock, earn interest on the proceeds of the short sale, and buy a future to ensure you then bought the stock back at the same price.


You can construct a synthetic buy-side futures contract by buying a call and writing a put. If it trades lower, they will certainly exercise their put against you and, if it trades higher, you will certainly exercise your call! Either way, you buy it.


Therefore, to compensate your free money if you short the stock, earn interest on the proceeds, and buy the stock back at the same price using a synthetic future, you must pay more to buy the call, and get less to sell the put. So far as I can tell - and I'm pretty weak in the math department - the puts and calls trade as if they are equi-distant from the current price expanded by the risk-free interest rate to the expiration date.


Now why, rather than stock-index options reflecting a symmetric distribution, do puts seem to imply fat tails on the downside? You have to remember what an option is, it's a right to lean on someone. The ability to absorb leaning and risk - to be a shoulder to someone else's uncertainty - is a function of economic wealth. As the stock market rises, the systematic ability to absorb risk rises.


The ability to accept price X for an option is not a function of the price of the stock. Rather, both the ability to take on a short option, and the ability to carry a long stock, are a function of liquidity in the economy. People who can afford to buy stock can afford to sell calls. People who cannot afford to buy stock cannot afford to sell puts.


So the level of the stock market is a measurement of the ability of the economy to absorb uncertainty. People think volatility means rapid movement of the indexes in either direction when, in reality, it is only movement to the downside that constitutes volatility. Movement to the upside is a measure of the absence of volatility. The more volatile stocks are going to be, the less people can afford to pay for them.


It's really so simple, and yet it is very hard to explain or understand, and the error is widespread in both academia and on The Street. You go to Emanuel Derman's derivatives section on the Goldman Sachs web-site, and you see he has some crazy, ridiculous scheme for hedging volatility - so as to create replicating portfolios to manfiatucre and sell volatility options. He goes long every put and call up and down the strike-spectrum or something, so that he has no delta or gamma, only vega.


In reality, as volatility rises, the stock market falls, and you can hedge volatility almost perfectly by buying deep-out-of-the-money puts. This is demonstrated by looking at any chart, I don't know why people second-guess their own eyes! The VIX doesn't rise as prices move fast, and fall as prices slow, the VIX rises as prices fall, and falls as prices rise! Prices fall because of uncertainty! Anybody who buys a deep call to hedge an increase in uncertainty - assuming if the stock jumps volatility has risen - is an idiot!


Have you ever heard anybody say "I don't know where the economy will be a year from now, so, hmmm, I guess I'll pay 100 times earnings as soon as I'll pay zero?" No, that is a false symmetry! When you have no idea how fast the economy will grow, it is not equally likely to grow at 10% and -10%. Economic prosperity is a product of information, which leads to accurate planning, minimizes misspent money, minimizes the amount of money wasted on insurance, on airport screening, allocates capital to the most profitable uses!


Even Black Scholes is wrong, the cost of an option is nothing more than the cost of hedging. Meaning, options transactions arise from asymmetric hedging costs, not asymmetric volatility expectations. A covered call writer sells cheapest because he incurs no hedging liability, followed by a floor operator surrounded by clerks who can get in and out cheaply all day, followed by an off-floor writer who can only buy and sell in awkward clumps.


Suppose you hedged a call by buying every time it crossed above the strike, and selling every time it crossed below. Okay, let's say a print at five cents above, vs. five cents below is your tirgger. If it is now currently $1.00 above the strike (and you are long the whole offsetting position), what is the chances it will reach the strike - forcing you to lose 5 cents at least once before expiration - and how soon is it likley to make first-cross - meaning how many times will you expect to lose 10 cents on additional crossings before expiration?


The price you charge to "manufacture" the call is the sum of the number of times you expect to lose 10 cents, buying above and selling below the strike price (assuming you choose 5 cents). As it nears the strike price from above, the chances you will spend 10 cents at least once rises. One way you can hedge this is by selling some stock right away, so that you make a profit as the chances you will lose 10 cents at least once rises.


So you suppose you are short a call you wish to hedge, and you are a dollar below the strike price. You are long no stock. The chances you will have to buy some at the strike, and eat 5 cents slippage, are almost zero. But, as the price rises, and the chances it will cross the strike at least once rise, your liability rises. So you buy some tiny amount of stock that will exactly offset this growing liability.


At the moment it crosses the strike, you theoretically buy the whole offsetting position. But at this moment when it is sitting right at the strike is when your liability is highest, becasue it could just cross and cross, and force you to buy and sell and buy and sell, right up to expiration. As it moves away from the strike to the up side, this risk, this liability, goes down.


So you sell short some stock which you will lose money in at exactly the rate your liability declines. But since you are long a whole position, you sell short against that, and simply carry a smaller position. Eventually, you get so high above the strike price, and expiration is so near, that a further move higher is not likely to decrease your chances of a crossing-slippage anymore, so you unwind your last short, and are long the full offsetting position.


So, your strike-price-crossing transaction hedges the liability of the option payout. And your gradual transactions hedge the costs of your crossing transaction slippage. Next, you need to adjust your gradual transactions so that they hegde their own costs slightly!


So, ultimately, the cost of manufactuting a call is a function of the bid-ask spread - meaning your expected slippage when hedging. And the width of the bid-ask is a fucntion of how far people are willing to stick their necks out with limit orders, given volatility and gaps in price movement! So, whereas Black Scholes is contingent on there being no gaps in price movement, the cost of an option arises specifically becasue there ARE gaps in price movement!! Otherwise, hedging would be costless, you would lose an infinitesimal amount at every strike-price crossing to buy and sell.


As such, Black Scholes is wrong but, like so many chance evolutionary traits, it has survived simply because it produces a dynamic hedge ratio which happens to mimic hedging the cost of hedging (when you plug in the right inputs)! But when you look at the math which is incorrect and think it means something, and forget what an option really is, is when you get led astray. So you ask silly questions like why do puts imply an abnormal distribution, when the underlying premise is wrong.


Prices are always right, as they say, and the first place to look at if your math says they are wrong is at your assumptions. Or, you can just completely blow out like the Nobel-Prize-winning mathematicians at Long-Term Capital! Lucky for me, I can't do math, so I'm immune to many of these popular intellectual viruses!


eLROY

I will have to consider what you wrote for a while but consider the following.If you buy a stock and immediately sell an out of the money call on that stock it is the EXACT same trade as

selling a put.Since a call can be converted to a put and likewise a call=a put.Or, C-P=L.

Regarding LTCM,they are morons but rich morons and people can't wait to give them money.The trade they convinced themselves was gold, buying corporates and selling treasuries is a trade for a fool.I would never go that way.I would only go the other way at a pre-determined level.The name of the game is not making money every day but staying in the game over the long run.

Back to your essay.I will look at it over the weekend but I have a feeling that you have a tendency to make things more complicated than they are.