The Business of Options – Book Excerpt

Author: Martin P. O’Connell
Publisher: Wiley
ISBN-13: 9780471405573

» Where can I purchase this book?

» Saiba onde encontrar este livro

Are You Too Anxious to Win?

Before about 1979, computers were not in widespread use among professional options traders. In part, this was because of the limited availability of useful hardware and software, but the more important reasons were personal and cultural. Members of the Chicago Board Options Exchange (CBOE) and its competitors usually were not the products of graduate schools or of corporate management development programs. They were more like Wild West characters who wandered into town with no identity, no relevant history, not even much money. Many of them (myself included) had never made a trade on a stock or options exchange. Most had a lot of confidence and tolerance for financial risk. Many had good mathematical instincts, but few had classical mathematical expertise or an aptitude for computer work. Almost all were sole proprietors, trying to learn the business and to find a way to make a few hundred dollars a day. Social graces weren’t required.

In this environment, the potential applications of computers weren’t just ignored, they were scorned. Real men didn’t use mathematical models and they didn’t hedge their positions. A “stand up” market maker was supposed to make a living by making markets for the public in individual options or by taking shots on stock price direction.

Eventually, of course, the power of computerized analysis could not be kept out, and many traders — some looking for magic — gave it a try. They soon learned that their new tools couldn’t protect them from their human weakness and inexperience.

In 1979, it became trendy to have a secret computer program that would calculate the probability of winning on a particular position. These theoretical probabilities were discussed as facts by some of their users. Since many of us thought of ourselves as “born winners,” it made sense to us that we should have large positions that would almost surely be profitable. It was common in 1979 to hear a trader say something like “I did a 99.1 today.” That meant he had put on a position for which his (questionable?) program calculated a 99.1% probability of success.

It doesn’t take much imagination to think up a position (or a bet) that has a very high probability of winning, but, on average, will be a loser. No doubt, many of these 1979 positions fall into that category. In most of them, though, the long-term average result was not the big problem. The big problem was remote risk. It is common sense that, if your sole criterion for a position is that it has a 99.1% chance of winning, then maybe somewhere buried in that other 0.9% is a nuclear bomb. Among the remote nuclear bombs waiting for the 1979 crowd were:

- The Saturday Night Massacre: In October 1979, the Federal Reserve raised the discount rate by 200 basis points on a Saturday night. Markets went crazy during the following week. In some cases, call prices rose as stocks collapsed.

- The Hunt Brothers’ silver disaster: The Hunt Brothers were billionaires who bought a lot of silver in the late 1970s. In late January 1980, silver prices finally peaked at about $50/ounce, and then got ugly. The real panic came two months later when the price collapsed from $22 on March 24 to $12 on March 27. Apparently, silver was big enough to take the stock market with it. The Dow Jones Industrial Average (DJIA) decline was only about 20%, but it seemed like a nuclear bomb to some options traders. Other traders survived the decline, but got caught by the whip at the bottom.

In the options business, there can be a powerful temptation to seek out positions that have high probabilities of success, but that also come with excessive remote risk and/ or negative expected returns. Good dealers, speculators, and hedgers can overcome this temptation, both at the individual level and at the institutional level.

In practice, we often find that option traders think differently from other traders regarding expectations about the probability (or frequency) of winning. For example, if you talk to a foreign exchange spot trader who has just put on a position, you might notice that he really believes he’s going to make some money. He might even have reasons. Then, later, when he talks about the trade, he’s likely to use language that reflects that belief. He might say, “I was right on that position.” This means that the subsequent market action proved that his trade was brilliant. Alternatively, he might say, “I was wrong.” That means that the subsequent market action demonstrated that his trade was stupid.

In contrast, a good option trader can be expected to think quite differently. A good option trader will frequently make a trade even though he thinks it will probably lose money. Sometimes, this is hard to explain to the boss.

“You mean, we make trades, even though we think we’ll lose money on them?”

“Yeah, that’s a basic part of our strategy!”

In the options business, simple statistical concerns are often well clarified through the use of gambling examples. In this case, a dice example helps. Suppose I would like to bet that I can roll a 4 in a single roll of one die. Of course, if you insist on even odds, I’m not going to bet because I know I only have one chance in six of winning. On the other hand, if I can get 10 to 1 odds, I am going to make that bet. I am going to make it fully expecting to lose, and I am still going to think about it as a business.

Notice that the word “expect” might be used here with two different meanings. I expect to lose (meaning I’ll probably lose) but I have a positive expected return in the statistical sense. If I am in the business of trading options to make a profit, it is the statistical expectation that matters most. Usually, the appropriate attitude is to be statistically passive. That is, I don’t care how likely I am to win this time. I want to win on average. This is the attitude of an insurance company or a casino.

Suppose I make the 10-to-1 bet and roll the die and get a 2 instead of a 4. Was I wrong? Of course not. I’m no dumber than before the roll, and also no dumber than if I had rolled a 4. If I had rolled a 4, the result might make me feel brilliant. That feeling would be simple emotional weakness. To be statistically passive is not just to make a trade without thinking I know the result. It also requires ignoring the temptation to think that the result indicates the quality of the trade.

Our business is full of snappy inane slogans. Often these slogans sound clever and insightful. Many of them are stupid–or even dangerous. My candidate for the worst of them is “You’re only as good as your last trade.” Sometimes, traders say it and sometimes the boss says it. Weak bosses often say it indirectly. They can be too quick to praise or reward short-term successes and too punitive about short-term losses. Such bosses eventually get exactly what they deserve–their employees find ways to give 10-to-1 odds that I can’t roll a 4.

I don’t want to be in the kind of business where you’re only as good as your last trade. I can’t “know” what’s going to happen all the time. In the options business, the pros are statistically passive.

» Read an excerpt from book The New Health Insurance Solution

» List of United States Health Insurance Companies

» Read an excerpt from book The Lost Symbol by Dan Brown

Tigre de Fogo