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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Jeff Yass started as an option trader on the floor of the Philadelphia J Stock ExchangeJeff Yass: The Mathematics of Strategy Jeff Yass started as an option trader on the floor of the Philadelphia J Stock Exchange in 1981. He was so enthralled by the opportunities in option trading that he enticed a number of his college friends to try trading careers. During the early 1980s, he trained six of these friends as traders. In 1987, Yass and his friends joined to form Susquehanna Investment Group. The firm has grown rapidly and now employs 175 people, including 90 traders. Today, Susquehanna is one of the largest option trading firms in the world and one of the largest entities in program trading. Yass seeks out nuances of market inefficiencies through complex refinements of standard option pricing models. However, the essence of Yasss approach is not necessarily having a better model but rather placing greater emphasis on applying mathematical game theory principals to maximize winnings. To Yass, the market is like a giant poker game, and you have to pay very close attention to the skill level of your opponents. As Yass explains it in one of his poker analogies, If youre the sixth best poker player in the world and you play with the five best players, youre going to lose. On the other hand, if your skills are only average, but you play against weak opponents, youre going to win. Yass will factor in his perception of the skill and knowledge of the person on the other side of a trade and adjust his strategy accordingly. He is willing to subjugate or revise his own market views based on the actions of those he considers betterinformed traders. Yass has a quick mind and talks a mile a minute. We started the interview in his Philadelphia office after market hours and finished at a local restaurant. Although I had my doubts about Yasss restaurant selection abilities (for reasons that will quickly become evident), the food was superb. Unfortunately, the food quality was matched by the restaurants popularity, and hence noise level, leaving me with cassette recordings worthy of the deciphering capabilities of the CIA. We obviously appeared to be a bit strange to a group of nearby diners who upon leaving couldnt resist inquiring why we were recording our dinner conversation. ==== When did you first get interested in markets? ==== When I was a kid. I loved the stock market. I used to tear the paper out of my fathers hands to check the stock quotes. ==== Did you trade any stocks as a kid? ==== I loved TV dinners. The first time I tried a Swansons TV dinner, I thought it was so delicious and such a great idea that I wanted to buy the stock. I found out that Swansons was owned by Campbell, and I got my father to buy ten shares of the stock for me. ==== Do you still love TV dinners? ==== Yes, and I also love all airplane food. I agree with Joan Rivers, who says shes suspicious of anyone who claims they dont like airplane food. ==== I am not sure I still want to go to dinner with you later. So what happened to Campbell after you bought it? ==== The stock never went anywhere. ==== Fin not surprised. ==== It went up eventually. I would have done OK if I had held on to it for the next thirty years. ==== Was that your first stock market transaction? ==== Yes. ==== How old were you then? ==== Eleven. ==== Did you buy any other stocks as a kid? ==== When I was about thirteen, I bought Eastern Airlines. I flew to Florida at the time, and I thought it was a good airline. I also bought a realty company that eventually went bankrupt. I always lost. I remember my father saying to me, The stock was around a long time before you bought it. Just because you bought it now doesnt mean that it suddenly has to go up. In high school, I discovered options. I would check the option closing prices and find what I thought were huge mispricings. For example, one time Alcoa closed at $49 and the 45 call was trading only $2 1/2 above the 50 call. By buying the 45 call and selling the 50 call, I would lose $2 1/2 if the stock went down $4 or more, but I would win $2 1/2 if the stock went up $1 or more. It seemed like a great bet. I convinced my father to do the trade for me. The stock went up, and the trade worked out. ==== Did you do any other option trades in high school after that? ==== No, I discovered that the closing option price printed in the newspaper was really just the last sale, which could be very stale. For example, an option might have finished the day 11 bid/12 offered, but if the last sale was at 13, thats the price that would be printed in the paper. Once I discovered that these quotes were not real, I realized that most of the trading opportunities that I found were really nonexistent. ==== How did you even know about options in high school? ==== The company my father worked for issued warrants when they went public. I asked my father to explain warrants to me. Since a warrant is nothing more than a long-term option, I understood the basic concept. ==== After you graduated from college, did you go on to graduate school? Or did you go directly to work? ==== My plan was to take a year off and travel across the country. I did, however, end up going on one interview with an investment house, which I wont name. I was interviewed by the head of the options department. I think I might have insulted him, and I didnt get the job. ==== Since youre not naming the firm, why dont you be more specific. ==== Well, our conversation went something along the following lines: He said, So, you think you can make money trading options. I then told him about what I thought was important in making money in the options market. He asked me, Do you know this years high and low for IBM? I answered, I think the low was 260 and the high was 320, but its absolutely irrelevant. If youre wasting your time thinking about mat, youre on the wrong track completely. He said, Well, / know what it is; I think it is very important. I replied, Great! Just hire me and Ill show you why its immaterial. In our subsequent conversation he indicated that he didnt know the definition of beta [a technical term used to describe a stocks volatility relative to the overall market]. He said, I dont bother myself with that kind of stuff. I said, Terrific! Just hire me, and Ill explain it to you and show you how to use it. Amazingly, I didnt get the job. [He laughs heartily at the recollection.] ==== I know that youre a serious poker buff and apply many of the strategies of the game to options. When did you first develop an interest in poker? ==== I started playing poker during college. My friends and I took poker very seriously. We knew that over the long run it wasnt a game of luck but rather a game of enormous skill and complexity. We took a mathematical approach to the game. ==== I assume that youve played at casino poker games. Im curious, how does the typical Las Vegas game break down in terms of the skill level of the players? ==== In a typical game with eight players, on average, three are pro, three are semipro, and two are tourists. ==== That sure doesnt sound like very good odds for the tourists! ==== You have to be a very good player to come out ahead over the long mn. ==== Given that high skill level, what percentage of the time do you actually walk away a winner? ==== On average, I guess that I win about 55 percent of the time. ==== Does it bother you when you lose? ==== It doesnt bother me at all. I know that Im playing correctly, and I understand that there is nothing that you can do to smooth out the volatility. I rarely second-guess myself when I lose, since I know that in the short run most of the fluctuations are due to luck, not skill. ==== Is the strategy in poker primarily a matter of memorizing the odds for various hand combinations? ==== No, memorization plays a very small role. Understanding the probabilities sufficiently well to know which hands to play and which hands not to play is important, but thats just basic knowledge. The really great poker players have an understanding of proper betting strategy. What information do you get when your opponent bets? What information do you give up when you bet? What information do you give up when you dont bet? We actually use poker strategy in training our option traders, because we feel the parallels are very strong. I believe that if I can teach our trainees the correct way to think about poker, I can teach them the right way to trade options. ==== Can you give me a specific example? ==== Assume that youre certain that you have the best hand, and the last card has just been dealt. What do you do? A novice trader would say, I would bet the limit. However, that is often not the right move-even if youre sure that your opponent will call. Why? Because sometimes when you pass, hell bet, giving you the opportunity to raise, in which case youll win double the bet size. If you think that th-e probability is better than 50 percent that hell bet, youre better off checking. By using that strategy, sometimes youll win nothing extra when you had a sure chance to win a single bet size, but more often, youll win double the bet size. In the long run, youll be better off. So, whereas betting when you have the best hand may seem like the right thing to do, theres often a better play. ==== What is the analogy to option trading? ==== The basic concept that applies to both poker and option trading is that the primary object is not winning the most hands, but rather maximizing your gains. For example, lets say you have the opportunity to buy one hunded calls of an option you believe is worth 3 1/4 at 3, giving you an expected $2,500 profit. Most market makers wou Id say that you just buy the option at 3 and try to lock in the profit. However, in reality, the decision is not that simple. For example, if you estimate that there is a 60 percent probability of being able to buy the same option at 2 3/4, your best strategy would be to try to buy at 2 3/4, even though doing so means that 40 percent of the time youre going to miss the trade entirely. Why? Because 60 percent of the time youre going to win $5,000. Therefore, over the long run, youll average a $3,000 gain [60 percent of $5,000] in that type of situation, which is better than a sure $2,500 gain. ==== Were you aware of that analogy when you first started trading options? ==== Yes, the poker world is so competitive that if you dont fully capitalize on every advantage, youre not going to survive. I absolutely understood that concept by the time I got down to the options floor. I learned more about option trading strategy by playing poker than I did in all my college economics courses combined. ==== Are there any other examples you can give that provide an analogy between poker strategy and option trading? ==== A classic example we give all our trainees is the following: Assume youre playing seven card stud, and its the last round of betting. You have three cards in the hole and four aces showing; your opponent has the two of clubs, three of clubs, nine of diamonds, and queen of spades showing. Youre high with four aces. The question we ask is: What bet do you make? The typical response is, I would bet as much as I can, because I have four aces and the odds of my winning are huge. The correct answer is ... ==== You pass, because if he cant beat you, hes going to fold, and if he can beat you, hell raise and youll lose more. ==== Thats right. He might have the four, five, and six of clubs in the hole. You cant win anything by betting; you can only lose. He knows what you have, but you dont know what he has. ==== So what is the analogy to option trading? ==== Lets say that I believe an option is worth $3. Normally, I would be willing to make a market at 27/8/3 1/8 [i.e., be a buyer at 2 7/8 and a seller at 3 1/8]. However, lets say a broker whom I suspect has superior information asks me for a quote in that option. I have nothing to gain by making a tight market because if I price the option right, hell pass- that is, he wont do anything-and if I price it wrong, hell trade, and Ill lose. Along the same line, if a broker with superior information is bidding significantly more for an option than I think its worth, theres a very good chance that hes bidding higher because he knows something I dont. Therefore, I may not want to take the other side of that trade, even though it looks like an attractive sale. The point is that option trading decisions should be based on conditional probability. I may have thought that an option was worth X, but now that someone else wants to bid X + Y, I may have to revise my estimate of the options value. The lesson we try to teach our traders is that anything that seems very obvious should be double-checked. A great example to illustrate this concept is a puzzle posed years ago by Fisher Black of the Black-Scholes option pricing model fame. Imagine that youre on Lets Make a Deal, and you have to pick one of the three doors. You pick door No. 1. Monty Hall says, OK, Carol, open door No. 2. The big prize is not behind door No. 2. Monty Hall, of course, knows which door the prize is behind. The way he played the game, he would never open the door with the real prize. Now he turns to you and asks, Do you want to switch to door No. 3? Do you stay with door No. 1 or switch? [Reader: You might wish to think of your own answer before reading on.] ==== The obvious answer seems to be that it doesnt make a difference, but obviously that must be the wrong answer ==== The correct answer is that you should always switch to door No. 3. The probability that the prize is behind one of the two doors you did not pick was originally two-thirds. The fact that Monty opens one of those two doors and there is nothing behind it doesnt change this original probability, because he will always open the wrong door. Therefore, if the probability of the prize being behind one of those two doors was two-thirds originally, the probability of it being behind the unopened of those two doors must still be two-thirds. ==== I dont understand. This show was watched by millions of people for years, and yet no one realized that the odds were so heavily skewed in favor of switching! ==== You have to remember that youre talking about a show where people had to wear funny rabbit ears to get picked. The thing that confuses people is that the process is not random. If Monty randomly chose one of the two doors, and the prize was not behind the selected door, then the probabilities between the two remaining doors would indeed be 50/50. Of course, if he randomly selected one of the two doors, then sometimes the prize would be behind the opened door, which never happened. The key is that he didnt randomly select one of the doors; he always picked the wrong door, and that changes the probabilities. Its a classic example of conditional probability. If the probability of the prize being behind door No. 2 or door No. 3 is two-thirds, given that its not door No. 2, what is the probability that its door No. 3? The answer, of course, is two-thirds. Ironically, four weeks after my interview with Jeff Yass, the New York Times ran an article on the exact same puzzle. The Times article reported that when Marilyn Vos Savant answered this puzzle correctly in her Parade column in response to a readers inquiry, she received nearly a thousand critical (and misguided) letters from Ph.D.s, mostly mathematicians and scientists. The Times article engendered its own slew of letters to the editor. Some of these provided particularly lucid and convincing explanations of the correct answer and are reprinted below: To the Editor: Re Behind Monty Halls Doors: Puzzle Debate and Answer? (front page, July 21): One reason people have trouble understanding the correct solution to the puzzle involving three doors, two with goats behind them and one with a car, is that the problem uses only three doors. This makes the assumed, but incorrect, probability of picking the car (1 in 2) appear too close to the actual probability (1 in 3) and the solution difficult to arrive at intuitively. To illustrate better the right answer-that a player should switch the door picked first after one of the other two has been opened by Monty Hall, the game-show host-suppose the game were played with 100 doors, goats behind 99 and a car behind 1. When first offered a door, a player would realize that the chances of picking the car are low (1 in 100). If Monty Hall then opened 98 doors with goats behind them, it would be clear that the chance the car is behind the remaining unselected door is high (99 in 100). Although only two doors would be left (the one the player picked and me unopened door), it would no longer appear that me car is equally likely to be behind either. To change me pick would be intuitive to most people. Cory Franklin Chicago, July 23, 1991 To the Editor-: As I recall from my school days, when you are dealing with tricky, confusing probabilities, it is useful to consider the chances of losing, rather than the chances of winning, thus: Behind two of the three doors there is a goat. Therefore, in the long run, twice in three tries you will choose the goat. One goat-bearing door is eliminated. Now two times out of three when you have a goat, the other door has a car. Thats why it pays to switch. Kari V. Amatneek San Diego, July 22, 1991 And finally there was this item: To the Editor: Your front-page article July 21 on the Monty Hall puzzle controversy neglects to mention one of the behind-the-door options: to prefer the goat to the auto. The goat is a delightful animal, although parking might be a problem. Lore Segal New York, July 22, 1991 The point is that your senses deceive you. Your simplistic impulse is to say that the probabilities are 50/50 for both door No. 1 and door No. 3. On careful analysis, however, you realize that there is a huge advantage to switching, even though it was not at all obvious at first. The moral is that in trading its important to examine the situation from as many angles as possible, because your initial impulses are probably going to be wrong. There is never any money to be made in the obvious conclusions. |
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