Reminiscences of an Option Trader (ROT)
I have gotten over the first, so the creation of the second is in order.
I gave up long ago trading "direction." Stocks go up and down primarily due to sentiment, just what the market is willing to pay, so almost every gauge market participants have devised in trying to access "how long" and "at what price" stock prices change to is a guess at best. Guessing how market participants "feel" is not, I think, something to base a business on.
I have found that estimating the "rate of change" or volatility of a market is a higher confidence call: not "where" are prices going, but "how fast" are they going to get there. This is so only because option prices are frequently so mispriced that it becomes a probability game. I think having the odds in your favor is a good thing to base a business on. That is why there is a Las Vegas.
I live in a world where alternative universes exist. A 30% probability that never occurs is 30% real to me. In the end that particular universe did not materialize, but over time the average universe created by all those probabilities does manifest.
This is what risk is: loss not yet manifest. It is potential and if you estimate potential correctly, some potential materializes and some does not, but the average potential becomes real.
ROT is a good acronym for this column. My portfolio is one of derivatives which are contingent liabilities: the pay-off is path dependent, which simply means that it changes day to day, price to price. The largest type of derivative we trade is an option. It is the right to buy or sell an asset at a certain price over a certain period of time. This means that the option decays or rots away if nothing happens. So price is the degree of rot.
We can talk about that later in an example. What I simply do in general terms is price volatility. When people sell options cheaply they are saying there is not much value to volatility; the asset will not move much. When they pay too much for it, they are saying something is going to happen over this period of time and there is value to volatility.
I look at volatility as the price of liquidity: the more liquid something is, the less volatile it tends to be. If you are buying a stock that is illiquid, you might change the price by 20 basis points. If you are buying a stock that is liquid, you might not change the price at all. Which is more volatile?
There are many variables that affect liquidity/volatility: events (when an unexpected event occurs, liquidity dries up fast), leverage (small mistakes create tail events), available money (interest rates and monetary policy), price compression (the non-linear patterns stock prices exhibit), market structure (other people's money syndrome increases liquidity sometimes and decreases in others), etc.
It is these variables that we study; it is the over-lapping of macro fundamentals with liquidity that we have been reporting to you. We have to ask the question "why" things are happening to get an idea of the future effects on volatility. For example, tight credit spreads may be a reason why stock prices are currently grinding higher, but we ask the question why spreads are so narrow and what is the probability of them widening? When they widen we know that volatility will increase. For example, what does it mean that the yield curve inverts when real interest rates are so low, a phenomenon that we really have not experienced before (they have inverted several times when real rates were high).
I hope to show how we think in concrete examples once a week in this column.
Adam Warner and I will work together on this column to illustrate through example the "art" of volatility trading.
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