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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Can you give me a trading example of a situation where the obvious decision is wrong?==== Can you give me a trading example of a situation where the obvious decision is wrong? ==== Lets say a stock is trading for S50 and an institution comes in with an offer to sell five hundred of the 45 calls at $4 1/2. The instinctive response in that type of situation is: Great! Ill buy the calls at $4 1/2, sell the stock at $50, and lock in $1/2 profit. In reality, however, nine times out often, the reason the institution is offering the call at $4 1/2 is because its fairly certain that the stock is going lower. ==== Does this type of situation ever happen-that is, an institution offering to sell options at a price below intrinsic value [the minimum theoretical value, which is equal to the difference between the stock price and strike price-$5 in Yasss example]? ==== It happens all the time. ==== I dont understand. What would be the motive to sell the option below its intrinsic value? ==== In the example I gave you, the institution may be very certain that the stock is going to trade below $49 1/2, and therefore a price of $4 1/2 for the 45 call is not unreasonable. ==== Even if they have good reason to believe that the stock will trade lower, how can they be that sure of the timing? ==== The straightforward answer is that they know they have a million shares to sell, and that they may have to be willing to offer the stock at $49 to move that type of quantity. It all comes down to conditional probabilities. Given that this institution is offering the option at below its intrinsic value, which is more likelytheyre so naive that theyre virtually writing you a risk-free check for $25,000, or they know something that you dont? My answer is, given that they want to do this trade, the odds are youre going to lose. When I first started out, I would always be a buyer of options that were offered at prices below intrinsic value, thinking that I had a locked-in profit. I couldnt understand why the other smart traders on the floor werent mshing in to do the same trades. I eventually realized that the reason the smart traders werent buying these calls was that, on average, they were a losing proposition. ==== If ifs not illegal, why wouldnt the institutions regularly sell calls prior to liquidating their positions? It seems that it would be an easy way to cushion the slippage on exiting large positions. ==== In fact, that is a common strategy, but the market makers have wised up. ==== How has the option market changed in the ten years that you have been in the business? ==== When I first started trading options in 1981 all you needed to make money was the standard BlackScholes model and common sense. In the early 1980s, the basic strategy was to try to buy an option trading at a relatively low implied volatility and sell a related option at a higher volatility. For example, if a large buy order for a particular strike call pushed its implied volatility to 28 percent, while another call in the same stock was trading at 25 percent, you would sell the higher-volatility call and offset the position by buying the lower-volatility call. ==== I assume these types of discrepancies existed because the market was fairly inefficient at the time. ==== Thats correct. At that time, a lot of option traders still didnt adequately understand volatility and basic option theory. For example, if a call was trading at a 25 percent volatility, which was relatively low for the options in that stock, many traders didnt understand that you didnt have to be bullish on the stock to buy the call- If you were bearish on the stock, you could still buy the underpriced call by simultaneously selling the stock, yielding a combined position equivalent to a long put. The more mathematical market makers understood these types of relationships and were able to exploit pricing aberrations. Now everybody understands these relationships, and you no longer see situations in which different options in a same stock are trading at significantly different volatilities-unless theres a good fundamental reason for that difference in pricing. Now that everybody understands volatility, the major battle is in the skewness in option pricing. ==== Can you explain what you mean by skewness? ==== To explain it by example, the OEX today was at 355. If you check the option quotes, you will see that the market is pricing the 345 puts much higher than the 365 calls. [The standard option pricing models would actually price the 365 calls slightly higher than the 345 puts.] ==== Are options prices always skewed in the same direction? In other words, are out-of-the-money puts always priced higher than equiv-alently out-of-the-money calls? ==== Most of the time, puts will be high and calls wilt be low. ==== Is there a logical reason for that directional bias? ==== There are actually two logical reasons. One I can tell you; the other I cant. One basic factor is that there is a much greater probability of financial panic on the downside than on the upside. For example, once in a great while, you may get a day with the Dow down 500 points, but its far less likely that the Dow will go up 500 points. Given the nature of markets, the chance of a crash is always greater than the chance of an overnight runaway euphoria. ==== Did the markets always price puts significantly higher than calls for that reason? ==== No. The market didnt price options that way until after the October 1987 crash. However, I had always felt that the chance of a huge down-move was much greater than the chance of an upmove of equivalent size. ==== Did you reach the conclusion about the bias in favor of larger downmoves based on a study of historical markets? ==== No, nothing that elaborate. Just by watching markets, I noticed that prices tend to come down much harder and faster than they go up. ==== Does this directional bias apply only to stock index options? Or does it also apply to individual stock options? ==== The options on most major stocks are priced that way [i.e., puts are more expensive than calls], because downside surprises tend to be much greater than the upside surprises. However, if a stock is the subject of a takeover mmor, the out-of-the-money calls will be priced higher than the out-of-the-money puts. ==== Do your traders use your option pricing models to make basic trading decisions? ==== Anyones option pricing model, including my own, would be too simplistic to adequately describe the real world. Theres no way you can construct a model that can come close to being as informed as the market. We train our market makers to understand the basic assumptions underlying our model and why those assumptions are too simplistic. We then teach them more sophisticated assumptions and their price implications. Its always going to be a judgment call as to what the appropriate assumptions should be. We believe we can train any intelligent, quick-thinking person to be a trader. We feel traders are made, not born. ==== Essentially then, you start off with the model projections and then do a seat-of-the-pants adjustment based on how you believe the various model assumptions are at variance with current realities. ==== Exactly. ==== Can you give an example of how this adjustment process works? ==== A current example is NCR, which is a takeover target of AT&T. AT&Ts bid is $110, and the stock is currently trading at approximately $106. If the takeover goes through, the buyer of the stock stands to make about $2. (About half of the difference between the current price and the takeover bid represents interest rate costs on carrying the stock.) If, on the other hand, the takeover falls through, then the stock can drop sharply-to about $75 based on current market estimates. In this particular case, the relatively close calls are essentially worthless, because the stock is unlikely to go above $110. On the other hand, the much further out-of-the-money 90 puts have some chance of gaining significant value in the event the takeover fails. Thus, in this type of situation, the out-of-the-money puts will be priced much higher than the equivalent outof-the-money calls. ==== In other words, this is an example of how an option pricing model could yield very misleading projections in a real-world situation. ==== Right, because the standard model assumes that the probability of any individual tick being up or down is 50/50. That, however, is not the case here because theres a much greater probability for a large price decline than a large price rise. At one time, the mathematical types traded straight off their models, and in a situation like the one I have just described, they would sell the out-of-the-money puts because they appeared to be priced too high. However, the seat-of-the-pants types would look at the situation and realize that there was a real possibility of the stock witnessing a large decline [i.e., a breakdown in the case of a takeover]. The traders using a commonsense approach would end up buying the out-of-the-money puts from the mathematical types and taking them to the cleaners in the process. Eventually, the mathematical types caught on. ==== In your day-to-day operations, do you basically start off by looking at the model and then making certain mental adjustments? ==== Exactly. Our basic philosophy is that we have tremendous respect for market opinion. For example, if we believe an option is worth $2 and a knowledgeable market maker is bidding $2 1/2, we assume that nine times out of ten hes going to be right, because hes trading one stock and were trading five hundred. We will then try to figure out why hes bidding $2 1/2. If we can identify the reason and we disagree with it, then we may sell the option because its overpriced. But most of the time, well decide that his knowledge is better than ours, and well end up adjusting our valuation on the other options in that stock and then buying these other options or the stock itself. ==== When you adjust your option valuations because someone else is bidding at a price that appears to be removed from the theoretical value, are you simply assuming that they know more about the given company? ==== Yes, information doesnt exactly flow perfectly, like they teach you in Finance 101. Frequently, the information will show up first in the option market. A lot of these insider trading cases involve options, and were the people who lose the money. For example, just today they caught an employee of Marion Labs who obviously had inside information that Dow was going to offer a takeover bid for the company. This person had bought five hundred of the July 25 calls at $1 [total cost: $50,000], and the next day the options were worth $10 [total position value: $500,000]. In the old days- before options-someone with this type of information might buy the stock, and even assuming 50 percent margin, the profit percentage wouldnt be that large. However, now, by buying options, traders with inside information can increase their profit leverage tremendously. Sometimes I feel sorry for some of these people because, until the recent barrage of publicity regarding insider trading, Im not sure that many of them even realized they were breaking the law. However, since they come to the options market first, were the ones on the other side of the trade getting picked off. ==== I dont understand. Doesnt the SEC scrutinize the order flow when theres an announced takeover to make sure there are no suspicious orders? ==== Yes, they do, and theyre getting particularly effective in catching people trading on insider information. They have also become much more efficient in returning money to those on the other side of these trades. However, in earlier years, the process took much longer. One famous example involved Santa Fe, an oil company that was a takeover target by the Kuwaitis in 1981. At the time, the stock was at $25 and the option traders on the floor filled an order for one thousand 35 calls at $1/16. Shortly afterwards, the stock jumped from $25 to $45 and the options went from $1/16 to $10. The floor traders had a virtual overnight loss of about $1 million. Although they eventually got their money back, it took years. If youre a market maker and youre broke, waiting to get your capital back is not pleasant. You live in fear that youre going to be the one selling the option to an informed source. Eventually, everyone gets picked off, because if you try to avoid it completely, youre going to pass up a lot of good trading opportunities. In a nutshell, if youre too conservative, you wont do any trades, and if youre too aggressive, youre going to get picked off a lot. The trick is to try to strike a balance between the two. ==== Can you think of a recent example in which you were picked off? ==== The options for Combustion Engineering are traded on the Pacific Coast Exchange. The options rarely trade. One morning, we received a call from the board broker (the exchange employee responsible for managing order imbalances). He said there was an order to buy several hundred options and inquired whether we wanted to take the other side. The stock was trading at around $25, and we agreed to sell three hundred of the 25 calls at approximately $2 1/2. Ten minutes later, trading in the stock was halted, and there was an announcement that the company was being taken over by a European corporation. When trading resumed several minutes later, the stock reopened at $39, and we were out over $350,000 in a matter of minutes. It turned out that the buyer was on the board of directors of the acquiring company. ==== What ultimately happened? ==== In this particular case, weve already gotten our money back. The SEC identified the buyer quickly, and because the individual was a high-level foreign executive who didnt even realize he was doing anything illegal, he returned the money without any complications. ==== Given that consideration, arent you always reticent to till a large option order in a market that normally doesnt trade very often? ==== Theres always that type of reticence, but if you want to be in the business, its your job to fill those types of orders. Besides, in the majority of cases, the orders are legitimate and nothing happens. Also, under normal circumstances, we hedge the position after we fill the option order. In the case of Combustion Engineering, the stock stopped trading before we had a chance to buy it as a hedge against our position. We still would have lost money, but not as much as we did being completely unhedged. The more successful the SEC is in catching people trading on inside information-and lately they seem to be catching everyone-the tighter the bid/ask spreads will be. Every trade we do involves some risk premium for the possibility that the other side of the trade repre sents informed activity. Therefore, if everyone believes that the SEC is going to catch all inside traders, then the market will price away that extra risk premium. In essence, its really the average investor who ends up paying for insider trading through the wider bid/ask spreads. ==== When stocks have large overnight moves, is that type of price action normally preceded by a pick up m the option volume? ==== Almost always. If you go over the volume data for stocks that were taken over, youll Find that there was almost always a flurry of option trading before the event. ==== Do you do any directional trading? ==== None. Its my firm belief that the markets wisdom is far greater than mine. In my opinion, the markets pricing of an item is the best measure of its value. The odd thing about believing in efficient markets is that you have to surrender your beliefs and ego to the markets. Several years ago, a director of the Office of Management and Budget made a statement that budget projections should be based on the assumption that long-term interest rates would eventually decline to 5 to 6 percent, at a time when rates were over 8 percent. The market-implied interest rate level reflects the net intelligence of thousands of traders battling it out daily in the bond market. In comparison, the 0MB directors personal opinion doesnt mean anything. If hes basing government policy on the assumption that long-term interest rates will be 5 to 6 percent, when the markets best guess is 8 percent, hes doing grave harm to society. Presumably, if he were smart enough to predict interest rates better than the market, he could make a fortune trading the bond market, which he obviously cant do. My guess about where interest rates will be in the next twenty years is better than that of almost any economist, because all I have to do is look at where the bond market is trading. If its trading at 8 percent, thats my projection. Someone can spend millions of dollars developing an elaborate interest rate forecasting model, and Ill bet you that over the long run the bond markets forecast will be better. The general principle is that if you can give up your ego and listen to what the markets are telling you, you can have a huge source of information. ==== I know that your bottom-line advice to people regarding trading is: Don`t think that you can beat the market However, is there any advice you can offer for those who do participate in the markets? ==== If you invest and dont diversify, youre literally throwing out money. People dont realize that diversification is beneficial even if it reduces your return. ==== Why? ==== Because it reduces your risk even more. Therefore, if you diversify and then use margin to increase your leverage to a risk level equivalent to that of a nondiversified position, your return will probably be greater. ==== I tend to agree. I like to say that diversification is the only free lunch on Wall Street ==== The way I would put it is that not diversifying is like throwing your lunch out the window. If you have a portfolio and are not diversifying, youre incinerating money every year. The type of professional option arbitrage trading in which Yass engages obviously has little direct relevance to most ordinary traders. However, there are still some significant messages here that have broader application. Perhaps Yasss most important point is that it is critical to focus on maximizing gains rather than the number of wins. One obvious application of this concept is that regardless of your trading style, a betting (i.e., trading) strategy that increases the stakes on trades deemed to have a higher probability of success could significantly enhance the final results. Another point emphasized by Yass is that our initial impressions are often wrong. In other words, beware of acting on the obvious. |
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