View Full Version : Selling Naked Calls?

01-07-2002, 04:07 AM
In a thread below, Wild Bill says that there is positive EV in selling naked calls. I have heard this from others as well. The claim is that this "good play" is avoided by most people because of the risk involved. I think some believe that calls are generally overpriced because people like to go for jackpot scores. I have no idea whether this theory is correct or not but I am sceptical for a few reasons. One of course is the spread, which is very high on low priced, out of the money options. Also I would think that the price is kept down by those who are writing covered calls. They are hedging. And in all gambling that I know of, hedgers are taking the worst of it in return for reducing volatility. If so, the option can't be a pos EV sell. Add that to the fact that there are experts out there with big money who can easily afford the risks on both sides. Doesn't it stand to reason that they will drive down the price of an overpriced option?

Obviously if it is true that selling naked options is a bad play it would be because of the rare calamity that would befall the naked seller. But because of its rarity, meaning that the great majority of naked sales show a profit, might it not be that this widespread belief that selling naked options is positive EV, is in fact wrong? I believe we have readers out there who KNOW the right answer to this question and I hope they tell us.

01-07-2002, 10:13 AM
I suspect nobody "knows" the right answer in the sense in which you mean it. The reason is it is impossible to arrive at a generalized assumption without, instead, choosing a specific strategy.

If you were, at 10:00 on Monday morning, to hit the bid in every US exchange-traded call in which there was a published bid, and do only the size at the inside bid, would you expect to make money - even ignoring the "cost" of volatility - if you held them to expiration? I don't think so.

But, on the other hand, I certainly could not guess! And any prolonged study of the problem performed by actually selling calls pursuant to the strategy, would at first drive down their price, and then increase the apparent utility for calls - so that calls would likely be overpriced the month the study ended!

There have been numerous academic studies as to the generalized pricing of options - and many people who "know" one thing or the other as a result - but they are all hogwash. It's like trying to attribute the residual of why men earn more than women "with the same education."

Men and women with college degrees, the men earn more. But wait, men are more likely to also have masters degrees. Men and women who have masters degrees, men earn more. But wait, men are more likley to have masters in econometrics or chemistry, women in sociology.

Men and women who both have degrees in econometrics, there is still a residual difference. To what do we attribute it? And can we then extrapolate this to men and women who both have only bachelors in psychology?

So, in calls, if we choose anything apart from the strategy I proposed, you are left wondering, is it something about our strategy, or something inherent in calls themselves? Plus, another concept you miss is asymmetric utility, which I addressed briefly in the following post:


When I go to the grocery store, I find that toilet paper is almost always selling way too cheap, and so I buy some every time! But if I were to do a study which suggested that toilet paper is too cheap, and the grocery store should raise the price to where I would be indifferent to doing without it or finding a substitute, I would not escape the ridicule that the answerer of your equally-silly question will escape.

Is it possible to make a profit in the options market? Yes, and nor is it a zero-sum game. Are calls, in general overpriced? Well that depends on whether you - as an individual - in general, have no use for calls.

Are there individual suckers who, in specific instances, probably pay more than they should for calls? Yes. If there were a simple, or academic-texture strategy, for selling a diversified portfolio of calls, would entire companies evolve to take advantage of it, as they did in the 1980's? Yes.

I honestly believe that, when I worked as a runner serving an options pit - and most order flow was in contracts on the move - that a big part of my job - upon which the very fate of the exchange rested - was moving just slowly enough that 50% of the paper orders I carried were stale by the time they arrived at the pit.

Then, upon my delivering a customer limit offer below the "fair" bid for instance, competing market-makers would all bid higher than where the customer "would have been willing" to do business. But few of them would bid at a price were they could not make money, at least those who did wouldn't last for very long. What is their replacement rate?

All economic profits are the result of asymmetric friction. If there are a million firms with fixed overhead invested in plant and equipment to sell calls, and then the sucker call-buyers dry up, and I can turn buyer rather than seller faster than anybody else, I win. Or, if they can all either buy or sell, but are in business to do one or the other, I can kick back and pick and choose - and pick them off.

Or something...

Point is, simple answers make suckers.


01-07-2002, 10:48 AM
My goodness. Where did all that come from? I was just wondering whether selling a general category of naked options, such as out of the money calls, (getting no special price break) has shown a long run profit. Just like I might have asked whether betting every bowl game dog has. It was not a theoretical question and certainly had nothing to do with utility or other investment alternatives. When I said some of our readers might know the answer I didn't mean they would because they are smart. Rather I assumed that someone has historically checked out this system on paper, published the results, and that the results were read by someone on this forum who could tell us about them.

01-07-2002, 11:13 AM
I find this thread amusing.I and many of my friends have long term(over 15 years) winning records trading options.Most of us do not use any fixed system. Sometimes we sell naked options!

You seem to be looking for that magic "black

box" system.Forget about it!FridayI made a recommendation in the bond options.No analysis

was needed.I said I had bot feb 98 puts in the bonds and sold feb 97 puts in the bonds.For each 98 put I sold 2 97s.I did this at 12 credit and said they were still a sale at 5 credit.This is a delta long trade and the bond market was down on friday and yet this trade still made money.Think about it.A computer would have told you with the market settling 10 ticks lower on friday this trade should have lost money..but it picked up a few ticks.As a matter of fact the 98 put was down 1 tick and the 97 puts were down 2 ticks!the trade settled at 2 credit from the previous days 5 credit.

01-07-2002, 11:15 AM
1) It may not be impossible to check out this system on paper, but that hasn't stopped almost every academic or paper study of the problem from being misleading if not worthless. Paper studies of options are notorious for their very "paperness," much more so than bowl games. Not only are there more execution complications, but there are more people doing studies!

2) I am very touchy about the idea that, by "curve-fitting" a strategy - finding a set of inputs which would have yielded a theoretical profit in the past (and choosing from a sufficiently large pool of candidate inputs that such a strategy will certainly be found) - suggests anything about the price of options, or about the future profitability of the strategy, or even answers your question!

So, if you want the simple answer to your question, yes, in the early 90's I did your study using 12 years of Wall Street Journals which I bought from a guy in Hayward CA, so that I could figure in news stories to see if they helped advertise the jackpot illusion. I had recently finished writing a "complex expectations" options-pricing program for Windows and, to my surprise, it seemed to suggest that most options were over-priced! So I was curious was it garbage-in-garbage-out, or could I make a profit, so I did the study.

The study confirmed that a study will often show that calls are over-priced. And what I'm telling you is that anybody who answers your question is silly!

But I'm also taking it a step further. The correct thing to study is not the behavior of options prices, but the behavior of people who perform studies, and who in turn create options prices with their transactions!

There have been many academics who came to Wall Street armed with studies. Milken used Braddock Hickman's "Corporate Bond Quality and Investor Experience, 1900-1950" - as a sales tool if nothing else - and made a fortune. David Askin used his own studies of experience with difficult-to-price mortage-backed securities and got killed.

I guess the bottom line is that the stock market is an out-of-control knowledge-production machine. Charts are like Rorschach charts, you can see in them whatever you want, and then write the word KNOW in capital letters.

And I can't stand to watch people learn nonsense!

It irritates me if someone writes an article in a newspaper advising investors to always use limit orders, or someone writes a post saying you can make money selling calls, or if someone says you can buy and hold stocks and you will make money!

In reality, stock-market knowledge is generally wrong as soon as it is produced. So if I simply say, "look what people have learned to do and do the opposite" I will also be misleading. The question is, how fast do people evolve to do one thing and, once they have, how long will they continue losing money before the opportunity vanishes?


01-07-2002, 11:29 AM
You are correct sir! Also when you sell a naked option you should have a sense of what you will do if you are wrong and when you will do it.This is not always possible however and I have a good example.Last year the price of natural gas ran up from 4 units till over 9 units in a short time.

California was having brown outs and there was talk of storms in the Atlantic near the gas fields.The "analysts" were calling for MUCH

higher prices.I looked at the 20.00 unit call that expired in approx 5 weeks.They were trading for 1,800.00 each.I sold a few and waited to see

what the futures were going to do.A week later

the futures were trading at 10 units and yet those same options were offered at 150.00 each!

There was no way to hedge the options I sold effectively.They were lotto tickets.They had priced in the end of the world!I just thought they were a sale and it takes a lot for me to just sell options naked.

01-07-2002, 11:29 AM
Usign Bayes theorem we can show that, even though people who win in poker or sports betting are infinitely more likely to bet or play again than people who lose, that there are so many people gambling on the weekend and earning a paycheck during the week, that survival rates don't substantially change the texture of sports betting or poker. Or if they do, at least the texture change operates slowly and steadily in one direction over a period of years, rather than being complex or cyclical.

In most stock-market situations, the current pool of players is not mostly newcomers, but a large percentage of people who have survived previous or recent rounds. Add to that the different nature of a football bet where your bets don't affect the skill of the players, and the stock market where the bets actually change the supply and demand and cause the outcome, and you find there is almost nothing more dangerous than stock-market "knowledge!"

So that is why I came back at your question with an incomprehensible gobbledygook. Because that is what people are in for if they start down that path.


01-07-2002, 11:41 AM

01-07-2002, 11:46 AM
Call sellers need only get killed once every century to invalidate a 90-year study.

Any arbitrarily short study of options prices will show that those who bought options didn't get paid, and those who sold them did.

As you increase the length of the study, the number of times option buyers get paid, and the number of time sellers get killed, rises. This is true, even if only slightly so, at any sub-infinite length study, no?

Meaning any study, given that it does not extend from the beginning of time to the end, is more likely to exclude periods when call buyers got paid than when call sellers did. So what it shows, at its most sensitive, is a function of the length of the study. Am I wrong?

For a real-world example, I think biotech-stock options were jackpot-priced all thoughout the 1980's. Then Clinton came along with his health-care thing, and anybody short bio-tech puts got absolutely wrecked. But by that time, the bear-side jackpot players had gone broke and turned over many times.


01-07-2002, 11:48 AM
>The claim is that this "good play" is avoided by most people because of >the risk involved.

It's also avoided by most people because, unless you're a Market Maker on an Exchange, the margins are high.

But it's still not a good play as you will soon see.

> I think some believe that calls are generally overpriced because people >like to go for jackpot scores. I have no idea whether this theory is correct >or not but I am sceptical for a few reasons.

This was true in the early days.

Nowadays, when a low price option is very overpriced, it could well be because, say, Morgan Stanley or Goldman Sachs, or one of their huge customers, might have a bit more information than you.

So, we are left with the anomaly that, many times the goofier the price of a low price option, the worse the sale is.

>One of course is the spread, which is very high on low priced, out of the >money options.

The Bid/Ask is much narrower these days.

>Also I would think that the price is kept down by those who are writing >covered calls. They are hedging. And in all gambling that I know of, >hedgers are taking the worst of it in return for reducing volatility.

Sometimes the hedgers make a low price option even more expensive. When they're worried that the SEC or an Option Exchange might suspect that they traded on inside info, they need plausible deniability.

They get this by coming up with a plan that requires some lopsided spread which involves buying a lot more of the cheap options than they sell of the expensive ones.

>Obviously if it is true that selling naked options is a bad play it would be >because of the rare calamity that would befall the naked seller.

Calamity is an understatement.

It's very, very sad.

I can still remember the faces of all of these people.

At least ten Market Makers who committed suicide because they went broke selling naked options.

At least five ex multi-millionaires Market Makers who are now broke. They originally made all their money by selling naked options.

One Market Maker and one retail broker who most would judge to be almost insane. e.g. one of them walks around the city going from McDonalds to McDonalds eating Big Macs. Again, it was selling naked options that did it.

> But because of its rarity, meaning that the great majority of naked sales >show a profit, might it not be that this widespread belief that selling >naked options is positive EV, is in fact wrong?

Sklansky's got it right.

01-07-2002, 11:59 AM
I will say it again.You have to pick your spots!

There are no golded rules or guarantees.

01-07-2002, 12:04 PM
One thing I always hear is how options market-makers are afraid of being picked off by inside information. But isn't it usually the laws against insider trading that bust market-makers?

Meaning, any piece of information becomes a fact slowly. Company X is thinking of buying a smaller company in another geographic region. Company X is looking at Companies Y and Z. Company X is in talks with Company Y. Company Y is receptive to Price N, etc.

And any piece of information normally spreads gradually from person to person. Jack has a zit. Jack has a rash. Cindy says Jack dated a girl with Herpes. Liz, Jack's neighbor, whom nobody knows, saw Jack buying herpes cream at the store. Sally sees other girls avoiding Jack, and wonders if they know something she doesn't, etc., pretty soon jack can't get a date in this state.

Meaning, if people were allowed to trade on inside information, so stock prices moved gradually, market-makers wouldn't wake up in the morning to find their stock had jumped 40 points, and their life is over! I hate the SEC, and this Reg FD only makes it worse!

Any agreeers, disagreers?


01-07-2002, 12:14 PM
Buying many out of the money calls and selling the more expensive near the money calls is a fantastic way to make money "if" you are convinced about the direction of the market and looking for

a rapid move. For instance(I am not recommending this but I am watching on a daily basis)the coffee

options.If the market seems to have stalled and I can put on some " ratio backspreads" they could be very profitable.

About the bid and offers or spreads in options quotes.The bond market is extremely liquid and if you can call the floor direct it is not uncommon to get a "choice" quote where the bid and offer are the same.

01-07-2002, 12:23 PM
The profitability of options depends on their moneyness and maturity in addition to the asset. Do you include options only on individual equities? What about indices? What about commodities or options on futures? How do we weight all these options? Over what period?

Importantly, options are usually hedged. Since the market has generally risen, call options have tended to appreciate. This is particularly obvious in the case of in-the-money LEAPS. But they may have appreciated less than an equally-risky stock portfolio. So a better issue is the profitability of at-the-money straddles.

01-07-2002, 12:46 PM

01-07-2002, 04:27 PM
I'm not entirely sure about equity markets, but with regard to interest rate markets, selling at the money option straddles has on average made money. I suspect this is also true for out of the money and equity options as well. There are a few theories that i know of regarding this matter. Essentially, the idea is that because the option seller is selling insurance and therefore has a skewed risk profile, they need to be compensated by a risk premium. Also since volatility is greater on crashes than rallies, options straddles are more likely to pay off when the market is selling off, making it a negative beta instrument.

Of course, the fact that selling option straddles are positive EV does not make it a good play as your downside potential is much greater than upside... hence the risk premium required. Also, margins will further distort this.

01-07-2002, 04:56 PM
One of the many interesting things Javelin points out is how you may get a positive EV from someone buying an option when that counter-party is also getting a positive EV.

Meaning, you are a seller and he is a buyer at the same price, and yet you both make money!?

He makes money because, somehow, the combined portfolio of his equities and his bond options becomes more valuable. You make money because, well, you make money - he gives you a piece of the action for being there.

But it is important to notice that a guy who writes bond straddles for a living might not be a natural counter-party, but rather a middleman. Meaning, he cannot hold them until expiration, and make money in the long run, he has to find a natural counter-party. Why? For one thing, he may have the same equity exposure - and the same volatility averseness - as the guy buying the straddle.

In other words, if you are the equity guy buying the long bond straddle, you have to ask yourself why is this option under-priced? Everyone owns stocks or something! What kind of freak, be it a collection agent, or someone in a high tax bracket, would consider this price expensive?

Okay, I ran a little thin there...

Other interesting things to recall are 1) the impact of interest rates on the pricing of things which create positive and negative cashflows at different points along the time axis, and 2) the pricing of volatility as a cost, whereby a 50/50 chance of .50 or $1.50 is worth less than $1.00.


01-07-2002, 05:37 PM
If you read my post more carefully, you'll notice that i claim that option straddle sellers get positive EV... NOT option buyers. Of course as options are zero sum, option buyers get negative EV

01-07-2002, 05:56 PM

I must confess to being baffled. You are the one who gave "reasons" why some sucker would pay "too much" for straddles. Your reasons, essentially, were that he is not a sucker!

For instance, if he owns stocks and you don't, then he can hedge and diversify his stock portfolio by betting on an increase in implied volatility in bonds. Or, maybe he is just more risk-averse than you, meaning for you a 50/50 shot at 1.50 vs. .50 is worth .99, for him it's only worth .98!

The simplest proof I can give that options are not a zero-sum game is that, if they were, the most successful options and futures traders would have bankrolls no bigger than the most successful poker players. But for some reason, the suckers are willing to manufacture billionaires in futures?

I don't think so. They suckers are getting something out of it. If you care to explore this further, here are some 2+2 posts dealing with this concept:





I think this stuff is important to understand, or at least interesting, since it is how most people on Earth make money!


01-07-2002, 06:07 PM
Ok, i see whats going on. When i refer to options as being zero sum, i'm talking in cash terms... of course in utility terms they are not zero sum.

Second, i never claimed that you would be a sucker to buy options when their EV is negative... thats my whole point... that option sellers get a positive EV but that this is to be expected and a fair risk premium.

01-07-2002, 06:37 PM
A single option transaction in isolation is a zero sum game assuming linear utility of cash. Viewed as closed systems, options markets and futures can be considered zero sum ... but if they were truly closed systems, they wouldn't even exist.

However, the real world is an open (non-equilibrium) system, in which the financial markets are components. So even if we assume linear cash utility of real market participants, it can be a positive sum game because the hedger can now safely make more money from whatever opportunity he needs to hedge ... and in the real world, the hedger can make that money not by swindling it from suckers but by creating value (e.g., by manufacturing or providing services) so that both the hedger and those purchasing what the hedger creates benefit (even in terms of linear cash utility).

01-07-2002, 07:03 PM
My thinking is this:

Suppose, based on correlation to other things they own, there are people willing to pay you cash to sell them bond options - and you just swallow the volatility yourself.

Sklansky asks, will not enough people compete for this free money that it should disappear? I mean, even if there were only one guy on Earth who could stomach the volatility, he would quickly get rich enough to sell all the options you wanted, and he'd have to hold some back like OPEC.

More likely, in my opinion, there would also be natural counter-parties on the other side, who based on some natural need would be willing to pay you cash to buy options from them - covered call writers, in effect.

Any one of these people could get free money from the other, even though he would have been willing to pay. As such, whichever side is smaller, it gets made up by cash traders, the theoretical guy with no external utility or correlation.

Ultimately, the only way you can get free money, relative to other opportunities, would seem to be if you are unique. Because, let's be honest, nobody is volatility-indifferent, everybody has a different utility for some payout scheme, and everybody is correlated to something, even if only by being a waitress in the financial district.

I think the last guy who is going to A) get free money, and B) expect it, is the cash guy. And remember, future money which you can't count on today is not as useful as money which you can count on. So either A) somebody is using a bad model, which causes free money to keep popping up over and over "unexpectedly," or B) somebody is missing a cost or utility somewhere when he measures cash payout.

Aren't you glad to know my thinking?

Seriously, this phenomenon of free money...

I give up,

Wait, we can fall back on the laws of evolution! If free money is favoring the survival of people who sell bond straddles, or need them as natural counter-parties, and yet their population doesn't grow to where the nourishment runs thin, there must be some unseen factor killing them off. Who knows, it could be a world of bottomless abundance, bad math, or even disbelief!


P.S. A quick tutorial in "beta" for anyone bored enough to read this far, and who doesn't know what we're talking about:

Suppose a dollar is worth $1.00, a 50/50 chance of $1.50 or .50 is worth 98 cents to you, and a 50/50 chance of $2.00 vs. 0 is worth 95 cents.

If there are two .50/1.50 investments, and they are perfectly correlated, you will be willing to pay 98 cents for either one. But once you already own one or the other, the second one is now worth less than 98 cents to you. Or, if they are perfectly inversely correlated, you will be willing to pay MORE THAN $1.00 for one, assuming you already own the other! Right?

Buying the beta -1 instrument brings the value of the other instrument from 98 cents to a $1.00, or something, you do the math. So what does this have to do with option prices?

Well, suppose there is somebody who has a use for stock, so he is willign to submit a high-friction limit order to an exchange - and give someone else the opportunity to lean on him - just to get some stock. Notice, a buy-limit order is identical to a put to a market-maker over the time it takes the customer to cancel it!

So, with enough of these high-friction limit orders to lean on, an options market-maker can sell puts, and then sell short stock into limit orders as the market collapses to hedge himself the whole way. And sellers can then sell to the option hedger on the way back up, they all make money, and everyone is happy /images/smile.gif

Positive-sum game...

01-07-2002, 07:07 PM

01-08-2002, 04:01 AM
>>Add that to the fact that there are experts out there with big money who can easily afford the risks on both sides. Doesn't it stand to reason that they will drive down the price of an overpriced option? >Obviously if it is true that selling naked options is a bad play it would be because of the rare calamity that would befall the naked seller. >But because of its rarity, meaning that the great majority of naked sales show a profit, might it not be that this widespread belief that selling naked options is positive EV, is in fact wrong? > I believe we have readers out there who KNOW the right answer to this question and I hope they tell us.

01-08-2002, 04:04 AM
...Add that to the fact that there are experts out there with big money who can easily afford the risks on both sides. Doesn't it stand to reason that they will drive down the price of an overpriced option?...

Of course this is true for a lot of stocks but as Ray has pointed out many times that the big money stays out some stocks basically because there isn't enough liquidity. I suppose that some opportunities may present themselves because of this.

...Obviously if it is true that selling naked options is a bad play it would be because of the rare calamity that would befall the naked seller. ...

IMO there is a big difference between shorting puts and shorting calls so I assume we're talking about shorting calls.

...But because of its rarity, meaning that the great majority of naked sales show a profit, might it not be that this widespread belief that selling naked options is positive EV, is in fact wrong?...

FWIW I don't think in general that shorting calls is +EV. I don't think options are priced that way and from my understanding market makers generally don't assume the risk of a short call, they transfer the risk and are basically involved in an arbitrage activity for lack of a better term.

...I believe we have readers out there who KNOW the right answer to this question and I hope they tell us. ...

I really don't know of any particular study but I'll try and find one. I can't prove it but I actually believe that right now there are many under priced out of the money calls in several of the big cap NASDAQ tech stocks. Again I can't prove it but I think buying slightly out of the money calls will be profitable for 2002. If I was employing such a strategy I'd go long the calls for the next month the day the previous month's options expired and buy them each month expecting to lose more often than I win but when I win it would more than make up for the losses.

01-08-2002, 08:14 AM
>IMO there is a big difference between shorting puts and

> shorting calls so I assume we're talking about shorting calls.

Please don't make this common blunder.

There's little difference in the results

of being short massive positions

in low price Calls or in low price Puts.

Almost half the traders mentioned went,

one way or another,

on October 19, 1987.

01-08-2002, 09:13 AM
I believe you Erin.For the 3 quarters prior to the crash my friends and I talked about pooling about 15k together to buy S&P puts.We felt the market was overvalued and we were going to buy a bunch each quarter.Woulda,shoulda,coulda, we never did.We did sell some way out of the money calls at ridiculous prices after the crash however.

01-08-2002, 09:31 AM
You know, that average floor-piker who lost 52.5 million in two days? (CBOE, OEX puts.)

I think Tom's blunder may be more accurate when applied to off-floor/retail traders. Floor traders often get wrecked by fast moves and gaps, which happened plenty to the upside in CitiCorp, Chrylser(?), other buyouts, and throughout the Internet era.

But for off-floor traders, usually any big move over time is a gap - since they don't hedge dynaimically - and they are usually net long the market. Since they post monster margins, the move of a size required to blow them out would have to be some surprise negative revelation about a company.

When we talk about stocks shooting to the moon, and covered call writers and mutual-fund investors, usually it feels more like oxygen than the Option Grim Reaper.

Also, it may very well be that bond options have a lot of volatility because people have a long memory going back to 1982, and the absolute Keynesian/Argentina doomsday scenario.


01-08-2002, 10:57 AM
I am just a mathematician in finance, basically a brownian motion specialist and what I am saying might not be of any interest for you.

However it is worth noticing that far out of the money vanilla options are directly used in the hedging of exotic European options.

This is due to the Peter Carr's theorem which states that the price of every Cē European payoff functional can be replicated as a weighted sum of vanilla options at different strikes (including far out of the money strikes). What is beautiful is that you heve a direct exact hedging of the option without making usual greeks hedging.

This can also be extended to interest rate options as a weight sum of vanilla caps/floors.

And I know for sure that a few years ago some banks did not understand why major banks did sell such far out of the money options and it was because of the above mentionned reason, that is the hedging of exotic OTC options.

01-08-2002, 11:00 AM
read "why some major banks did buy such far out of the money options" obviously

01-08-2002, 11:39 AM
At the following link, so far as I can remember - and given my limited mathematical ability - Derman suggests that you can hedge volatility by buying a continuous portfolio of long options, or something:


Is that basically the idea? Or did I miss something?

Then, buried deep in the following post, I argued that, based on the inverse correlation between stock prices and uncertainty, that you could probably construct a simpler hedging strategy for volatility:


Might you do me the favor of, like, correcting my paper here - explaining in non-mathematical terms where I have been led astray?

Also, please tell the forum more about what you mean by vanilla versus European/exotic options, and how it is relevant. I might not understand it, but someone will!

Finally, so far as Brownian motion, I would not dismiss it, but rather celebrate it as the number-one fair-value discovery tool in all of finance!


01-08-2002, 12:02 PM
I didn't bother reading the articles you referred

to.I can state the following should you choose to belive it fine.I only stae it from my 20 plus years of experience.When it is possible you should hedge options with options.Other wise you end up

"delta-trading" which to me means buying the highs and selling the lows.

01-08-2002, 12:33 PM
Yes, the vol swaps is precisely inside the Peter Carr framework : you suppose u are in a Black Scholes framework with a deterministic time-dependent volatility, u can write the today's expectation of the realized variance of the stock as a function of the todday's expectation of the logarithm of the stock at the expiry date.

Now by Carr's theorem, u can derive the expectation of the logarithm of the stock as a continuous portfolio of calls with different strikes (this portfolio can be discretized through a few (less than 10) options but this portfolio still contains far out of the money options)

01-08-2002, 12:39 PM
Hedging is often an illusion, with "portfolio insurance" during the 1987 Crash being my favorite example. The trick is that there is almost always an assumption hidden somewhere, and that is the one that will crack.

Why? Because something has to. This is because hedging is often nothing more than the sale of something without pricing it in, without actually locating a counter-party. In other words, a hedge delivers to the seller the illusion of buyers whether or not any actually materialize, while at the same time it delivers to buyers the illusion of the absence of sellers. Let's use the example of crude oil.

The demand for oil at various prices is basically fixed in the short term. If it is cheaper, people may buy bigger cars, and so on. But nobody can be sure what the demand for oil will be. So, if you have borrowed money to build oil wells, and you have to pay a bond coupon each month, and oil costs a fortune to store once you pull it out of the ground, you might buy crude oil puts for each delivery month.

So someone sells you these puts based on the idea that either - and this is important - 1) they know better than you that there will be a strong demand for oil, or 2) they will dynamically hedge, by selling oil futures as your put strike price is approached. Notice, in neither case do they actually sell oil in the cash or futures market - sellers who think the price could go up and buyers who think the price could go down never do - and so the true supply of oil is not priced into the market.

Only one of two things can happen. Either 1) the out seller they will find the expected buy-side liquidity into to which to dynamically hegde on the way down - meaning the oil producer never needed to buy a put - or 2) the put seller will blow out and go broke. But whatever the number of buyers, they will be LESS THAN the number of buyes there would have been had the crude producer sold immediately - because consumers evolve and adjust infrastructure and lifestyles around prevailing prices!

Frankly, when I look at Enron or electricity in California, I cannot tell you exactly what happened, only that true demand wasn't priced into the market. The week before Enron collapsed, an old friend actually stopped by my house trying to sell Enron-counterparty electricity calls and futures to local businesses door-to-door! They actually had this girl out on the street selling electricity futures!

More abstract example. Suppose corporate bonds have a default rate such that 10 corporate bonds will deliver the same cash-flow portfolio as 8 government bonds. If government bonds sell for $1.00, corporates should sell at 80 cents, right? So, you can construct a portfolio that is contingent on the correlation of corporates to governments.

But what happens if corporates drop to 79 cents? I mean, the correlation is useless unless you actually intend to exploit some type of arbitrage, right? Everyone will buy corporates and sell treasuries. But then, how could corporates ever fall to 79 cents in the first place??? Ultimately, it becomes a duration problem.

The only timeframe in which a portfolio of corporates can actually fulfill a correlation to governments is in the duration of the actual coupons. But people who bet on the correlation may be betting for a normalization of relationships in a year or less. Meaning, the counter-party to their transactions is the coupons themselves. Meanwhile, demand to atcually buy these coupon streams today may be utterly non-existent, except the to the extent people trading on the correlation propped up the illusion of demand.

Okay, I'm lost, I forgot the point. Oh, but who will buy the bonds?

So that is what we saw in 30-year treasuries last November. On the one hand, all these people were getting short squeezed for whatever reasons while, on the other hand, interest rates based on true demand and expectations were actually way up here - as they found out a week later! Derivatives camouflage supply and demand, because it is difficult to trace what people are buying and selling back to actual conditions.

Derivatives rely on the construction of assumptions rather than the actual location of counter-parties. Meanwhile, the assumptions are only accurate so long as nobody tries to exploit them. Hedges and correlations don't spawn counter-parties, rather the opposite is true, they spawn company on the same side. As in 1987, or in Erin's example, the tipoff to mispricing in the underlying is the supposed mispricing of the derivative, or something.

Going back to Renaud's option example, which I don't entirely understand, you had a situation where one group of banks was buying all these calls, and another group was probably selling them, saying "What are these idiots doing?" Meanwhile, those call purchases were probably the only tipoff to a potential avalanche if the exotic derivatives they were hedging ever became due, the music stopped, and everybody was forced to find a chair or an actual counter-party.

Derivatives can be used to mask the absence of counter-parties. If you can sniff this out, you can make a fortune. But, since it is usually buried so deeply, this brings us back to Brownian motion. The only way to see the washout emerging is when the tip of it starts surfacing on the tape. At first, people trade against it, they say "This can't be happening, these two things are correlated."

A moment later, it becomes self-fulfilling, and everyone - everyone except the Turtles that is - gets swept away. Because nobody understands what I just wrote, and I don't know what I'm talking abotu either. And, in a world of people who have no idea what is going on, prices rule, and trend-trading - which is a cost in itself to the extent it creates chop and masks prices - is still the only safe way to go.

Anyway, there is actually a financial-engineering innovation to solve this, a sort of mine-clearing tehcnology which could make the world about a trillion dollars richer overnight. But I won't bore you with it:)


01-08-2002, 01:01 PM
"Material non-public information" is created in the first place by the SEC. Because almost no information becomes "material" instantaneously. Rather, it is only by accumulating unreleased that the difference between previous and current releases can become material.

For instance, there is a chance that this week a "fastpass" or frequent-airline-security-timesaver-pass program will be marketed for management by Sabre Holdings, the airline-booking company in Texas (TSG). Sometime in the next few weeks or months, Sabre could theoretically decide to experimentally adopt the program, and begin overlaying necessary software and infrastructure upgrades.

Eventually - and this is a longshot - there could be a pilot program, accompanied by a news release stating,


Or something...

At which point the stock could jump like 50 cents.

But anybody suggesting anything like this today could be prosecuted for starting a "rumor." So, is it material, or is it a rumor?? It's neither. It's an immaterial fact, a remote possibility. But, thanks to Reg FD - and to trial lawyers' obessions with the word "could" - companies are prohibited from disseminating immaterial facts which could slowly, over a period of time, evolve into facts.


01-08-2002, 01:23 PM
If you are an oil producer you do fences.You sell calls and buy puts with the premium.You collect a credit for equidistant options.

Golden rule..don't short treasuries and buy corporates..the road to ruin.

Look at the open interest in the Dec Bond 110

calls prior to the fed announcement last year.

There should be an investigation.

01-09-2002, 03:27 PM
All your double talk and big words are designed to hide the fact that YOU ARE AN IDIOT. You contradict yourself from one post to another, call noble prize winners idiots and generally babble.

01-09-2002, 04:56 PM
Based on your opinion (that eLROY is an idiot), do you have any recommendations for him or for the rest of us?

My preference would be to hear more new thoughts from eLROY, regardless of whether they contradict his previous ones.

By the way, when eLROY disagrees with work published by Economics Nobelists, he is often correct in claiming that something is wrong.

01-10-2002, 07:38 AM
Maybe not.

I'd certainly disagree with him contradicting himself. The posts of his that I've read make the same points consistently.

1. Price is relative to the conditions of the transaction. That is, the first seller did not lose money to the middleman simply because the middleman sold it at a higher price. Rather, each took the best opportunity each could of their respective situation.

2. He advocates trend following

3. Trend followers could do better if they were not reacting to each other's signals which simultaneously creates a more unfavorable market for the lot of them.

If you can find a contradiction here, or perhaps in some other message, clue me in.

I have a question for eLROY. Isn't the exploitability of the market to trend-following a trend itself? What is meant is that the market, be it commodity or stock, is sometimes trending and sometimes it's jumping back and forth. What do you do when there is no clear trend? Is that the whole point of "collusion", to delay or perhaps suppress the markets adaptation to trend-followers and their signals?

01-10-2002, 12:11 PM
1. Price is relative to the conditions of the transaction. That is, the first seller did not lose money to the middleman simply because the middleman sold it at a higher price. Rather, each took the best opportunity each could of their respective situation.

So if the middle man makes money, then who lost it? Or do we live in a world where hyper-inflation is imminent? If it is a positive sum game, wouldn't people figure it out and just create wealth? Then the price of goods would go up and so on and so on....

2. He advocates trend following

From eLROY: In reality, stock-market knowledge is generally wrong as soon as it is produced.

So it someone observes a trend, is that not knowledge?

3. Trend followers could do better if they were not reacting to each other's signals which simultaneously creates a more unfavorable market for the lot of them.

So it is better to set the trend than to follow it?

BTW does anyone know the actual Long-Term Capital story or are you just assuming they were wrong?

01-10-2002, 01:58 PM
That's why I said "generally." Even car wrecks take a little while to unfold after the point of no return.

As a result of that, so far as nightOwl's question, my contention is that the markets would be trendy even if trend traders didn't chop it up so much. Meaning, people adapt to trend traders by trading counter-trend, so the trend traders don't even need to fine-tune their own texture, so long as counter-trend traders know when to fade them and when not to, and compete to do so.

"If it is a positive-sum game, wouldn't people figure it out and just create wealth?"

Yes, billions of them every day, would create wealth. That is why the amount of currency - scraps of paper - can keep rising, and still everything you can use currency to claim keeps getting cheaper. For statistics to back this up, go to:


So far as LTC, Meriwether, "admits" he was wrong, even though such an admission may simply be an unpleasant step to raising more money.

So far as "setting" the trend, if you mean executing only a portion of your order, which other people see hitting the tape and then clean out the offer before you can get anymore, only to sell to you higher, that is bad. You should be picking off the offer yourself, based on the only asymmteric information you have, knowledge of your own size behind.

But if you mean buying an apple instead of an orange today, so that fruit growers see this and start tearing up orange trees in Florida to sell the land to build condos and use the proceeds to plant apple trees and hire labor in Washington - if you mean someone extrapolating your current surprise demand into a business decision which will reallocate capacity to make your purchase cheaper in the future than it would have been had you not shown them a serially-correlated blip of your emerging need, to meet - then it is good to be a trend setter. Meaning, if you set the trend on your own side, by having your buy followed by other buyers who are not you, you lose by makign yoru good more scarce, but if your buy triggers a trend anopng selelrs, you win, or something.

Course, it becomes tricky in stocks where consumers are really just longer-term middlemen.

So far as stock-market knowledge being useless, the basic restriction on the evolution of knowledge is the fineness of texture, analogous to the wave frequency and number of wave coefficients in a given strategy. Most often, the different coefficients are the product of independently-evolving entities, whereby the harmonic sum and feedback between different pulsars creates a more complex signal than any of the individual pulsars could produce.

So the challenge is to be more complex than your surroundings, and yet be in one place. You want the learning to place inside of you and limited to you, not involcing teh combined evolution of you and a far-flung collection of adjusting particpnast around teh globe. In other words, you might call most stock-market evolution exosomatic. A structure which does not have sufficient initial complexity to sort junctions out of - like a baby's brain - can only evolve to interact with a complex-topology-source signal as part of a group.

The basic idea of OFT or "Orderly Feedback Theory" is that it is only possible for the rodeo rider to not get thrown off the bull if he has more joints than the bull, and can model the bull's patterns, together with the bull's environment, and still have neural connections left over. The entropy of an object must be equal to the entropy of all objects to which it is adjacent, to its environment, on all super-spheres and sub-speheres. Otherwise, adjacencies will be thrown off in a process called "junction burning" or "busting" and, in the commodities markets, "bankruptcy."

This self-preservation of sub-atomic particles by synching up with the waves as dissipated in their environment, and their working as teams in orderly lattices/networks so as to dissipate shocks propagating across space in an orderly fashion, is what prevents macro wormholes, or non-3-dimensional space from surviving or perpetuating - I think. Irregular topologies get fried, by magnifying and refracting complex shocks.

My favorite supply-chain metaphor involves picturing a tank of water with random inflows and outflows, where it is your job to keep the water level at the height of your own eyes, by opening and shutting an in-faucet and an out-drain in reaction. Now suppose there are two or three other remote, anonymous people also attached to the same water tank, with the same job, will you be able to evolve coordinated responses, a division of labor, without talking to one another directly?

Assume that your only "communication" is the water level, meaning it costs you to communicate, and random external shocks could be mistaken for communications? Will you guys settle into a predictable, self-resolving game? Or will your lowering the water at the same time as somebody else opens his drain cause it to go too low, so that everbody opens their in-faucets at once, and now it is four times as high, 16 times as low, and so on, until the amplitude gets so great that one or more of the un-cooperate-able parties gets tossed off?

Now, picture the same situation, except where what is your individual eye level is going up and down relative to the target eye-level of others regulating your same tank, because you're floating in another, different tank, regulated by other stangers, and so are each of them. The brains have to be more complex than the super-arrnagement of people, faucets, and tanks they compose. If the brains can't get more complex, the system will break down and, by destruction, get less complex.

OFT, and evolution, it's all about how fine a texture you can adapt and reflect internally - by pruning down your own internal synapse-feedback junctions so as to model data sets at your own sensory boundary along the time axis - your own internal entropy, on all neurological sub-spheres.

Lazy/sloppy answer, I admit, but you asked.


01-10-2002, 02:18 PM
BTW does anyone know the actual Long-Term Capital story or are you just assuming they were wrong?


When Genius Failed: The Rise and Fall of Long Term Capital Management by Roger Lowenstein

01-10-2002, 02:24 PM
Also, _Inventing Money_ by Nicholas Dunbar.

01-10-2002, 05:05 PM
One of the interesting things about people who engage in closed-system thinking is that they believe in the free-floating animistic fallacy at the same time. Meaning, they are wrong at both ends. They think it's all in your head - things manifest as a result of our thinking them - but at the same time there is only one universal frame of reference, it can be complete and accurate for all heads, and it must be internally consistent based on simple logic proceeding from popular initial assumptions (and which assumptions we should all "reasonably" agree upon).

We saw examples of this back in the limit-order thread - where a group of academics believed that by making the free-floating decision to refer to the NYSE specialist as "she," they could change the resultant texture of sexual occurence on the exchange floor - as well as in my discussion of the animistic fallacy with Craig H - where I pointed out the flawed thinking of propagandists who imagine that simply by getting the large masses of people to believe something you can make it so. Then again, without the idea that influential individuals can engineer the world, you can't write very interesting fiction.

With Marco, we have an example of a person who equates wealth with currency - with dollar $igns in effect. And he inquires whether it is better to be a trend setter or a trend follower - as if you can decide to be either, as if you can roll dice to pick which country to invest in and when, rather than having your opinions formed for you, by a process of Darwinstics selection among opinion leaders and popular ideas.

Review the Marco model. The properties of wealth and of money are equal and overlapping - and can be respresenetd by a dollar sign and all the words which that sign is associated with. And in a world of cause and effect, of intentions emerging from nowhere (or emanating from the human spirit) and free-floating results, we have trend setters and trend followers.

Years ago, I had my eye on a smart-looking uzi for sale, for a couple hundred bucks at a local store. Finally, the week before the new assault-weapons ban went into effect, I made up my mind to go buy it - only to find out another guy had beat me by four hours, and had paid four times what the tag had been for however many months prior. So naturally, I wondered, had the subset of weapons chosen to be banned statistically coincided with the weapon I had considered to be smart-looking?

Was it all an image thing? And were these images a free-floating feedback loop, an internally-consistent popular cartoon world, with no basis in reality? What physical properties did the weapon actually possess in my mind, could it shoot straight, or was it just scary?

So I went around asking people what they thought of the new Federal Assualt-Weapons Ban, recently signed into law by Congress. Universally, people wrung their hands and nodded their heads, and said it was a Good Thing, Very Good. I then defied every single one of these people to define for me what subset of guns qualified as "assault weapons" - or, alternatively, to draw me a picture of what their idea of an "assault weapon" was.

But not one of them could! They could barely even say, well, "it's a black, mean-looking thing," much less a cheap, lightweight rifle, mass-manufactured at low cost for foot soldiers by communist planned economies. Or something. The images they had seen in the movies had not even imprinted a cartoon on their minds which they could draw upon.

So what had even taken place, what was the physical manifestion of this ban, other than that they wouldn't be scared? Or was any such physical connotation, such as a reduction in feelings of violence - okay, a reduction in actual murder - even contemplated?

So, I got to thinking, if people could talk all day wihtout having any idea what they were taliking about, could not a computer be programmed to do the same thing? To talk about it all day, did a computer need to have any idea of what an assault weapon was beyond a few word associatons, such as black and pointy and "mean, greedy, black-haired men?" Could you simply construct a two-axis/nine-square physical-categorization table for words in a symbol-association network, by which all phenomena could be explained, and all sequences of words could be translated into other words?

The two physical-property axes were "good" vs. "evil" and "subject" vs. "object" - plus some colors and so forth. In other words, Bill Clinton is good, as well as a leader - by being an animator or a "mover" in the words of Craig H. He has good intentions, and can choose to be a trend setter. A tree is also good, but it is an object of good and bad intentions, and does not have its own intentions. The only internal debate comes up over the friendly dolphin, which is universally defined as being good, but whether it is good as a mover, doing good deeds, or as a mov-ee - in need of being on the receiving end of the good deeds of others - is in question.

Note, the core physical-descriptor table only has nine squares - good-neutral-evil by manager-inanimate-managee - and there is no spot even for simple tools, which convey transitive properties, for instance. There are just leaders and followers, good and bad, and inbetween.

In other words, the dolphin has feelings - same as trees - but also may be more animate, more self-directed than the helpless ghetto/welfare mother in "need" of health-care coverage (which coverage can be produced out of thin air, merely by the good intentions of others who are also good, but are on the cause side of cause and effect). It's an interesting model of the universe, but it exists only in people's heads. And of course, it is only in the free-floating logic of Marco's symbol-association network that my model becomes self contradictory.

But I'm not talking about symbol manipulation pursuant to evolved rules, I'm not talking about mathematics. Nor am I talking about indentities, where rather than building a castle out of thin air, we discover two existing castles which happen to fit on opposite sides of an equals sign. I'm talking about reality, which is beyond the human ken. If you begin with an initial set of assumptions and proceed to build on them - only the initial assumptions are adjusted backwards to produce a feelgood result, or one consistent with what you were originally inclined to hallucinate, or the least common denominator perception of the mob - anything is true, so long as we wish it, and if only we could overcome the stubborn objections of reality-addicted meanies, like


P.S. I actually had a far more complete social/language model for a computer simulation of an articulate mob idiot than I have even touched on here, but I scrapped it - for obvious reasons.

01-11-2002, 11:44 AM
it is obvious to me now, trading is a "positive-sum" game. We should all drop everything and go be day traders......

01-11-2002, 02:00 PM
eLROY..I am sure you will not be offended but I think if you devoted more time to looking for

opportunities in the options markets,particularly options on futures your energies would be better directed.I have known a number of traders like

you and typically they didn't last long.Every angle and piece of information had to be scrutinized from 50 different viewpoints.Don't you ever just "feel" something is a good trade.

My guess is that you have had this feeling many times and failed to act on it.For example I was watching Soybeans for a while and wanted to

go long if the market got below 420 basis March.

I found a way to talk myself out of doing it.

I hate it when I do that...don't you?Sometimes you just have to let go...forget the all the research and math nonense.For instance Bonds have been up sharply a few days in a row now and the Feb options expire in two weeks.Are there some opportunities here? I think so.Don't be afraid to be wrong..it is going to happen.

01-13-2002, 05:54 PM
This is a very convulated way of saying it is difficult to generate excess return (which is basically what hedging is trying to accomplish by minimizing losses).

Selling naked calls, selling covered calls, taking on huge risk, etc. All the time honored ways of making an "easy" buck in the market. Doesn't happen folks. Being a top portfolio manager is like being a top poker player...it takes both talent and experience.