View Full Version : options play? elroy's free-money spread...

01-11-2002, 08:05 PM
All math heads try to hedge changes in the underlying stock price, and in expected volatility - whatever that means. But what if we wanted to hedge against some sort of economic disaster?

The problem with buying stock-index puts, is that you lose as the market rises, and you lose as time passes. And, if the market does drop, you have already paid for fat tails, so you have to pick the exact bottom to exit to recoup this cost.

Moreover, near-the-money puts are mostly delta, and deep-in-the-money puts are mostly vega. So what you're holding changes as the market moves. So, if we buy near-the-money puts and prices rise, we gain vega as we move into the fat tails, but we get wrecked in delta. So if we start deep, we've already paid for the vega, and if we start shallow, to earn vega, we get delta, more or less.

The stock market rises as the positive-sum consensus for the economy rises, and falls as the positive-sum consensus falls. So is there a way we can bet on this, without simply selling short futures?

My hypothesis is that you could sell short futures, and hedge them by buying deep-in-the-money calls that are trading at intrinsic. Say the S&P is at 1200, you short 300 futures, buy 150 1000 calls, 100 950 calls, and 50 900 calls. If the market rises, or falls slowly, you break even. If the market crashes, you take off the position as each strike is crossed.

As your delta declines, and your futures become unhedged, your vega explodes. Suppose the market blasts right past your strikes, so that you're stuck unhedged. Unlike the long puts, the harder it is to time and unwind this strategy, the more money you make! The whole thing, so far as I can tell, is contingent on in-the-money calls not pricing in fat tails, more or less.

In other words, we are short stock, by being short futures. And we are long stock by being long in-the-money calls. So far as delta, we are hedged. But so far as vega, which is correlated to the delta in the stocks - because both are inversely proprtional to P or the positive sum of transactions - we end up hedging or betting on a liquidity crisis twice, both by being short stock and long volatility.

As stocks go down, calls do down but, unlike puts, they go up more! We have bought rights to lean on people and hedged against a glut of people to lean on at the same time. The long calls win whether there are too many people to absorb risk and stocks rise, are there are too few. And then we use the short futures to hedge the calls' delta, which we cannot do by buying puts and buying stock, because, well figure it out for yourself!

So, what have I missed, and why will or will not this strategy make money?


P.S. Dr. Bill, that was a nice trade in an otherwise choppy S&P the other day. Also, the reason I wrote such abtsract posts is because I WAS very busy at the time, and did not have time to come up with something focused, relevant, or novel, that's just the junk that bounces around in the back of my brain effortlessly at all times - and sometimes comes out.

But so far as your feel trades, you stated the problem perfectly. You saw a great trade, and yet talked yourself out of it. Why? Because you could not quantify it for yourself in black and white. I see this a lot in poker where, because a situation is a tough call, and the multiple variables are hard to quantify and weigh in the time alloted, you end up leaning towards doing what you feel like doing.

Rather than calling or folding an eqaul number of times, more often than not you use it as an excuse to call. The risk you avoid his how angry you will get at yourself, and how much confidence you will lose, if you fold incorrectly and lose the whole pot, rather than call incorrectly and lose a single bet. So you harness the gray-ness of the situation to become what you called a "hope trader." Maybe not you, but people.

In the market, you use your doubt as an excuse to stay out if you are out, and in if you are in. Then you always 1) think you were right, and 2) get frustrated. If you think about buying, but don't and then it rises, you say, well I was right to think it would rise. Or if instead it goes down, you say see, I was smart to smell trouble, and pass that one up.

And what allows most people to play these games with themselves is that they cannot quantify what they felt in retrospect, they are free to say they saw or felt whatever they want and, as such, they aren't really testing their assumptions! The never learn their strategy was wrong from a trade they didn't enter, instead, they learn to second-guess their feelings if it goes good, or either or, their ego is tied up in it too much, they elude themselves and refuse to be pinned down, to be wrong.

In other words, if you have a feel to start with - and some people do (I do but only when I start out broke) - you're fine. But if your feel stops working, or you start losing, and you can't even quantify what you've been doing, most poeple are screwed.

And most people don't have time to start out on the floor and load years of abstract observations and experiences into ther brain. All thay have is a chart - a fairly new and strange oddity to work with - and they can't afford to lose until they "get the hang of it."

So another beauty of a quantifiable strategy is that it can be discussed, and debated, and picked apart, and taught, like a religion. It doesn't just force people to sink or swim on their own instinct. And I really feel that one purpose of the two-plus-two sites is to take losers and turn them into winners fast, we don't get too many naturals here!

Also, this brings us to some issues between what is known as purely mechanical or "systems" trading, and what is known as "discretionary" trading. Let's look at them in the context of Jesse Livermore's two key factors in trading success, 1) sensitiveness to mob psychology, and 2) willingness to take a loss.

So far as sensitiveness to mob psychology, many traders will tell you that there is nothing they can add to a predefined computer algorithm, by overriding it with their own discretion. But even though they could, in theory, follow the same rules the computer follows without using a computer, what the rigid computer program offers that they cannot, is willingness to take a loss.

But I think this is just a matter of repetitions. When someone trading 10 instruments makes an average of four trades a year in each, for 10 years, he has what, 200 chances to learn to take a loss? You can get that many repetitions playing poker in one night.

With profitability dependent purely on how disinterestedly you muck losing hands no matter how much you have already invested in them, and on how fearlessly you raise winning hands even though you could just sit tight and still win, poker is often nothing more than a test of the ability to subvert your own natural tendencies. I don't see it as a real trading issue for poker players, but for traders, many need structure.

The next issue with mechanical systems is back-testing and confidence. The mob acts like the mob because they are free to act on hunches, which can steer you in different directions from moment to moment. To dampen your hunches, you freeze out action altogether.

Moreover, even if you have had steady success with a certain trading style over a period of years, it is hard to say that you wouldn't have had more success if you did something slightly different. Or you start to think, well, maybe things have changed. Without hard numbers, and a history, there really is no telling what you might do!

The only way many people are able to override their own instinct, and break this cycle, is when they know exactly how much money someone can expect to make or lose over the long run, doing one thing versus another. And you cannot have this much confidence in your judgment, not unless you are able to reduce it to an algorithm, program it into a computer, and back-test it over a period of years.

I think it is just silly, to look at a chart, or a string of profits, and say "I know what works" if you can't back-test it. It may work - but you won't - not unless you have cut-and-dry numbers to weigh, with a cool head. Or at least somebody might, but I wouldn't hope to be able to teach it.

The other main problem with computerzied - or at least rigidly structured - trading, comes about as a result of shortcomings in attempts to predefine and program what the eye can see. Given the limited ability of computers to associate as many different super-groupings of points as abstractly as the human eye, and given that larger "complete" or big-picture collections give you smaller statistical samples anyway, you are almost forced to use "discretion" in many situations.

But please, don't stop telling us about your trades! Rather, help us out by describing what you see, if you can!

01-11-2002, 10:21 PM
Not to complain about your advice which I am sure is useful to some, but do you ever post advice that is aimed for the average Joe that doesn't day-trade and isn't about to be approved for big money hedges? Not to mention when someone makes some kind of comment, can we do it without fearing getting ripped by you or some of the other number crunching experts because we didn't beat your concept of a fair return or we can't prove it with 20 years of historical data?

I guess what I ask for is why don't we have another board for the less sophisticated. I certainly don't think Elroy would suggest to us all that since we can't spend the time and have his tools to play the market that we should just shut down our shops and buy CDs with our discretionary income or our retirement funds. I would come write and interchange more on this board, but too many of these threads are just way out there where only mathematicians and scientists could contribute. I know I can't be alone here and I know there are others out here willing to contribute to these efforts. Sklansky and Ray Zee do put up nice threads that play more to the ease of use idea, then again maybe I am wrong and I should go back to the Yahoo stock message boards with all the scammers...

01-11-2002, 10:40 PM
There's some fairly accessible and sensible discussion along the lines you describe at the Morningstar web site.

01-12-2002, 10:25 AM
Let me see if i've got this straight. You short at the money futures, and buy in the money calls. Well, this is essentially the same as buying a put option. So you are simply arguing that this put option is mispriced because it doesn't adequetely take into account fat tail effect. If that's your bet, then thats fine, but this is not a free play.

Why don't you try putting actual numbers into your strategy, see what the pay-off profile looks like. Hull has a fairly good option pricer.


01-12-2002, 05:19 PM
Actually, I love everything you have to say, Wild Bill!

My simple advice is buy when the market starts to go up, and sell when the market starts to go down.

Or, to take it a step further as nightOwl suggested, trade for trends when the market has been choppy for long enough to kill trend traders, and you see the naked underlying trends starting to be exposed again. And then stop when it starts to chop up again. Chop trends. Trendiness pops up spontaneously, in one timeframe or another.

Also, I am no number cruncher:( We all have different skills, and the market is like that elephant in the dark, no? And so far as being an iconoclast, I just go after bad religion.

The stock market churns out religion by the season! Yet, the only religions which are worth Donkey Kong are those which have been around for thousands of years. And nor would I fault you your knowledegable understanding of complex economics! Trend trading has been around longer than value investing (since the stock market grew up on inside, not publicly-reported information).

But the stock market takes in a different kind of sucker. The flashing-lights-spinning-wheels dope is taken in by slots. The big-ego guy with an engineering degree or dominating social skills thinks he can take a poker game. The stock market sucks in a special breed of super-egghead. Beyond buy-and-hold, you have to be particularly smart before you even have a chance to do something particularly dumb! Moreover, the simple assumption that the buy-and-hold idiot is wrong - and you should short into him - also won't get you to first base.

So, there is a lot of pop-culture investment wisdom being propagated out there. As a stock-market expert (smirk), I can tell you the only advice I have come across that works year-in and year-out, and always eventually pops up someplace new - the only thing I have seen everyone from teenagers to hairstylists making money on year after year - is trend trading.

It may not be much, but trend trading gets you that fair positive EV you are due simply for being born - same as everything else. And the trend-trading SD is much smaller than buy-and-hold SD, you don't have to look at a 20-year timeframe to guarantee success, and yet you can still beat T-bills. In trend trading, your returns are serially correlated, and you have numerous of trials over short periods - periods shorter than the evolution cycle - so you know when to stop. (In case you want to say the same thign about buy-and-hold, you would just be making my argument for me!)

The thing about any stock-market advice is, if it becomes too popular, it becomes wrong. And anything that works becomes popular. So you can't always rely on just giving your money to managers with a track record though, in general, I would say that is good advice.

The beauty of trend trading is, with a little practice, you can see how popular it is just by looking at a chart! For comparison, it is awfully hard to sit and scratch your head, and figure out whether some new tech gizmo is fairly priced, or whether it is all just hype. Trend trading is the only form of contrarianism where you don't have to read minds, or say "Hmmm, Jeff Bezos is Time Magazine's man of the year - should I read something into that???"

So far as the Rose Bowl, I am still baffled by 1) how I became so baffled about two highly-televised teams, and 2) how I picked Nebraska, even though I had at one point visualized the game unfolding exactly how it did. So, anyway, I have a few thoughts.

Primarily, I hypothesize the BCS ranking has given people something new to think about, and has changed, slightly, the way they think. In the old days, if you second-guessed one of the two major polls, you were some kind of contrarian, or a free thinker.

But the BCS essentially institutionalized and publicized some of the types of cross-conference factoring many of us were doing in private already, only now they are more useless. In fact, they may have taken it too far in the other direction, where these factors are now contrarian indicators on the spread!

So I figured the matchup right, but the power wrong, or something. It was confidence-shattering, and I am thankful to have a year to hide my face in shame.


01-12-2002, 05:21 PM

01-12-2002, 07:25 PM
I was thinking, if nothing else, the magnitude of natural demand for way-below-current-price options would come in

1) buy puts,

2) write puts,

3) buy calls,

4) write calls.

By the time thes options became at-the-money, natural demand would have become,

1) buy puts,

2) buy calls,

3) write calls,

4) write puts.

So at entry, the current price of the synthetic put would be dictated by arbitrage. Meaning, the call would mainly have competing buyers to the extent they could still yield an arbitrage profit to a hedger, offsetting any excess natural demand selling to straight put buyers - who pay high commissions - and call sellers dynamically hedging against straight stock would, I don't know, also probably be natural sellers of volatility?

So, if nothing else, if you are in the pool of people to whom puts offer a natural hedge, and you have low friction/commissions, the synthetic put could offer a hair more free money than the put itself. Then, when we get to the exit side - meaning if the market dives - the arbitrage between at-the-money puts and calls should tighten, at the same time as we are in a position to leg out of the tough/illquid side - the calls - more easily as the market goes against us than we could if we were in puts and, instead of trend-trading, we were forced to pick a bottom.

There is one more angle to the "free-money" spread that I can't think of right now. I originally thought of it in traffic, and I just don't remember. Maybe you can think of it, or at least shed some light of actual experience on the scenario! I'm sure you get the idea, and I am no options trader anyway.


01-12-2002, 09:55 PM
when does the trend start and stop? after one minute or one day or one week. when do you get on. or do you buy when the s&p say for instance goes up a tick or ten points or what.

i dont believe that any follow the fools strategy has ever worked except for brief periods. or if it did you could just progarm a computer to buy and sell accordingly and go to sleep and wake up with all the money in the universe.

if you assume that the market if fairly valued at any given point in time, and thats a good assumption, then any tick off from the last is probably in the wrong direction, so you would be better off going against the trend. but that wont make money either.

oh, did i ever mentioned that stocks are valued according to their p/e ratio and almost nothing else. and will seek that level.

01-13-2002, 06:17 PM
Your whole thread here is the reason Wall Street types live like kings. Lots of activity (commission) and little in the way of understanding the market.

For example, if you were buying tech in Feb/early March of 2000 because it was trending up (way up!) you would have lost too much money to ever beat someone who was more prudent.

As for waiting until the market is choppy to weed out all the trend traders...you will have missed out on most of the 90's bull market with that strategy as you held on to your skirt while the market zoomed up. You must love this market now!! It's really choppy!

01-14-2002, 11:07 AM
About your S&P trade.Here is the problem.You want

to sell 300 furures and buy 150 1000 calls,100 950 calls and 50 900 calls.You need to tell us which month you have in mind.This is the same trade as buying the puts of those strikes except

1. you will have to lay out huge amounts of cash

2. Because these calls are deep in the money the

floor broker will build in a margin of error when

you get your quote.

3.I am assuming you are doing the futures and options simultaneously,if you are "legging in"

the above does not apply.Other wise you are better off just buying the puts outright.

Regarding my trading style.There are only a few trades that I have done that could be considered "black box" style trades.I am going to show you a trade that made me tremendous sums of money over the last last 20 years.One of my trading maxims is to admit things have changed and to get out.I was doing this trade for so long and had made SO MUCH MONEY over the years that at one point I considered only doingthis trade when it occured.Here it is.Idon't mind pasing it along now that it no longer works.I will admit taking a HUGE lumpbecause my refusal to get out last year when the trade finally failed.Here it is..Andbelieveme this was the holy grail.I could not figure out why the whole world did not do this.Take the price of the near term swiss franc futures price.Subtract the price of the near term deutschmarks price.Multiply that number by 4 and subtract it from the price of the DMark.When ever that number fell below 300 buy 4 dmark and sell

5 sf.For 30 years that number averaged about 800.

Two or 3 times the trade actually went to a credit but only stayed there for a couple of days.

I would start putting on "packages" at around 300

and keep averaging down.I didn't care how many I had.When the DM became the EURO I used the same formula using 1.95583 DM's to the EURO. I took a beating that took almost a year to recover from.

Here is the trade I legged into Friday after stating the bonds had been up sharply and there were opportunities in the Feb Options.This is not a trade I typically do because I did it for debits

and Ilike to collect as a GENERAL rule.I sold 30

Feb 105 calls at 18 and bot 20 feb 104 calls at

34.I did each one 2by 3for 10 debit.I may have reached to far for this trade.Normally, I would want credits for this type of trade as it gives you many more profitable exit strategies.

Regarding confidence,I don't need to reduce all

my trades to algorithims.All I need to know is I have consistently made money relying on my judgement.

01-14-2002, 12:21 PM
Okay, as a trend trader, I am suddenly buying tech in February/March of 2000. Where was I the previous 10 years?

What did you do, sell short in 1995 when P/E ratios got too high?

John, you don't know JACK. But I don't particularly care, except to the extent the popularity of your way of thinking is a good illustration of why trend-trading works!

But don't take my advice, perform your own statistical analysis of the chart, and see if it didn't exhibit serial correlation over a large set of coefficients! Heck, in the last 20 years, up years were 8 times as likely to be followed by up years, down years were equally likely to be followed by up years as down years.

I didn't invent this stuff, and nobody taught it to me. I just copied it from the people with the faster cars and the bigger houses.

And in case you haven't noticed, the retail commission houses, whether Merrill or E*Trade, have not had a whole lot of high living since the Seventies. Where have you been?

And so far as choppiness weeding out trend traders, the evidence of this is that the market has become trendy. Of course, you stated yourself that the market was a straight-up trend with no chop, so I am hard pressed to fatho, what we are arguing about!


01-14-2002, 04:05 PM
If so maybe that's when to buy em /images/smile.gif!