Selling Naked Calls?

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:


http://www.gs.com/qs/doc/volswaps.pdf


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:


http://www.twoplustwo.com/cgi-bin/ne...s.pl/read/1627


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!


leroy

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.

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)

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


eLROY

"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,


SABRE HOLDINGS GROUP (TSG), IN A JOINT VENTURE WITH GEMPLUS OF BRITAIN (GEMP), WINS FEDERAL CONTRACT TO MONOPOLIZE EFFICIENT AIRLINE SCREENING PROCESS FOR FREQUENT FLIERS - AS MANDATED BY NEW AIRLINE-SECURITY MEASURES RECENTLY PASSED BY CONGRESS. FUNNELED AND INCREASED BOOKINGS TO RESULT IN SKYROCKETING REVENUE. FORMER NEW YORK MAYOR RUDY GIULIANI, ACTING AS A CONSULTANT TO THE PROJECT, WILL PRESIDE AT THE UNVEILING OF THE NEW TECHNOLOGY TO TAKE PLACE THIS AFTERNOON AT LA GUARDIA AIRPORT.


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.


eLROY

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.

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.

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.

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?

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?