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Showing posts from February, 2018

Stigler’s Law and Option Pricing

Stigler’s law states that no discovery is named after its original discoverer. Some notable examples from science are: Halley’s comet, known since at least 240 B.C.·Venn diagrams, invented by Leonard Euler.Pythagorean theorem, probably discovered by the Babylonians.Avagadro’s number, discovered by Jean Baptiste Perrin.As a result of colonialism and eurocentrism, geographical discoveries are even more often attributed to the wrong people. According to a century of British schoolbooks, Mount Kilimanjaro was discovered by Johannes Rebmann. It is incredible that the people who lived on it hadn’t noticed it before.

Stephen Stigler came up with his law at a conference to honor Robert K. Merton, the sociologist and father of the Robert Merton of option pricing theory.Merton lamented that original discoverers seldom get the credit they deserve. In a piece of nerd humor, Stigler appropriated the comment, assuring that Stigler’s Law would be an example of Stigler’s law.
The obvious interpretati…

Volatility Trading and Risk Management

Last week was interesting.
There is actually NOT a Chinese curse that says, “may you live in interesting times”. Apparently, the whole thing was made up by a British diplomat. Nonetheless, a lot of volatility funds were cursed by last week being interesting.
There are many things volatility funds can do, so their returns have a wide range. I’ve seen numbers ranging from up 25% to down 95% (we made a few percent and thank you for your concern). The median was a loss of about 30%. This is because most volatility funds are option sellers trying to collect the volatility premium. I’ve written aboutthisalot. It is a perfectly viable strategy. So how did a professional fund lose 95%?
I don’t know. Thankfully I wasn’t in that trading room. But some of it may be down to misunderstanding trade sizing when returns are highly negatively skewed, as they are when short volatility. I’ve written about trade sizing in these situations before, but the general problem can be seen in a simple example.

We Don't Know as Much as We Think We Do

Traders don’t know much either. I’m not talking about general ignorance, but specifically that the history of markets is nowhere near as big as we often assume. For example, equity options have only been traded in liquid, transparent markets sine the CBOE opened in 1973. S&P 500 futures and options have only been traded since 1982. The VIX didn’t exist until 1990 and wasn’t tradable until 2004. And the average lifetime of a S&P 500 company is only about 20 years.
This might seem like a decent length of history that we can study and look for patterns. But I doubt that it is. I think that while there appear to be many thousands of data points, there might only be dozens. Options and volatility wiggle around a lot but their long-term values are related to macro variables such as inflation, monetary policy, commodity prices, interest rates and earnings. And these change on the order of months and years. Even worse, they are all co-dependent.
I think this makes quantitative analys…