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Some Dangerous Ideas

All trades can lose money. Even strategies with positive expectation don't win all the time. This is just the nature of math and the markets. But some trades are more dangerous than their statistics would indicate. Here are a couple of examples.

Mean Reversion Strategies

Mean reversion is the principle behind many trades. Spread trading, many volatility trades and some commodity calendar strategies rely on instruments staying close to a longer-term fair value.

The appeal is obvious. You get to buy low and sell high, and you have a nicely defined fair value that you can anchor to (both mathematically and psychologically).

But they can be tricky. A fairly minor issue is that the mean to which the instruments revert changes over time. As an example look at the VIX (which can't be directly traded but makes an easy example of this point). From 1990 to the present the VIX has had a mean of 19.4, and it has consistently reverted to somewhere around there.

Figure One: The VIX and its …
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Well You Did Ask...

We recently moved into some new offices in a co-working space. I love it. It makes admin tasks so much easier. There is free coffee. The staff is friendly and enthusiastic. And the other companies based in the space are, um, interesting… As far as I can tell, there is an “Uber for event planning”, several management consultancies run by people who have never run anything and at least two companies that advise other companies on how to market profitably while they themselves are losing money. I literally just wrote a paragraph on how dumb some millennial start-ups are, and I did that because I’m about to write a thousand words from the opposite cliched direction: the old man who thinks the new generation needs to sit down, shut up and listen to his wisdom. Last week I was at Global Derivatives USA 2017. It was great. There were several excellent talks and panels and the coffee breaks made it easy to connect with old friends and to also meet new people. At one of these, I was talking to t…

Straddles and Strangles Part 1

This is essentially a re-post of an entry from the (now dead) FactorWave blog. It is relevant again because it is the first part of what will be a series on strike and strategy selection.
One of the things that make options great is that there are many ways to express an opinion. But this is also one of the things that make options tricky. Just because there are many ways to express an opinion doesn't mean they will all be equally good. Some will be a lot worse than others.
Let's assume implied volatility is too high. While there are many ways to trade this, the two simplest are to sell either a straddle or a strangle. Here we are going to compare there two strategies. It is easy to work out the expected profit of an option position. It is just the position value at the volatility we sold at, minus the position value evaluated at the realized volatility. But obviously this doesn't tell the whole story. When selling options our upside is capped by the collected premium, but…

Equity Volatility is at All Time Lows

Well Maybe…

The author, explaining volatility to the kids of today.
There is no doubt that equity implied volatility is very low. As of October 13th, 2017, the VIX has closed below 10 on 41 occasions. 32 of those days have been this year. As the VIX is popularly known as a “fear index” this situation been labelled a “bubble of complacency” (which sounds like it should be located close to the sea of tranquility). This can be read as putting the blame for low volatility squarely on the shoulders of options’ traders, who actions create the VIX. But this is exactly backward. Implied volatility is low because of realized volatility being a lot lower.
But is realized volatility actually at an all-time low?
Generally, traders don’t have long careers. Bad ones lose their money or get fired. Competent ones see their specialty disappear. Successful ones end up in management. Few traders have any long term perspective. Their idea of history might be as short as five years.
I looked at 20 day …

The Kelly Criterion and Option Trading

(This is based on/cut-and-pasted from a paper that I co-wrote with Reuben Brooks.)
The Kelly criterion can be used to calculate the optimal size of a trade. Specifically, it gives the size that increases the trader's account at the fastest possible rate. It is possible that a given trader might not actually want this. She might want some sort of volatility or draw down constraint as well, but traders should still understand the ideas and implications of Kelly sizing. And misunderstanding abounds.
Generally, traders use an approximate form of the Kelly fraction that only takes into account the first two moments of the return distribution. While in many cases this can be a useful heuristic, when returns are highly skewed the approximation breaks down. In particular, for trades with identical expected returns, the presence of skew can drastically impact the relative sizing of long and short option positions.
Long option positions have unlimited profit potential and limited loss pote…