No, given that restriction, the assumption that prices are random is as good as any other assumption. However, just because Black and Scholes used a one-size-fits-all approach doesn’t mean it’s correct.
Don’t other firms such as Susquehanna [a company whose principal was interviewed in The New Market Wizards] also trade on models based on perceived mispricings implied by the standard Black-Scholes model?
When I was on the floor of the Philadelphia Stock Exchange, I was typically trading on the other side of firms such as Susquehanna. They thought they had something special because they were using a pricing model that modified the Black-Scholes model. Basically, their modifications were trivial.
I call what they were doing TV set–type adjustments. Let’s say I have an old-fashioned TV with an aerial. I turn it on, and the picture is not quite right. I know it’s supposed to be Mickey Mouse, but one ear is fuzzy and he is a funny color green. What do I do? Do I sit down and calculate where my aerial should be relative to the location of the broadcast antenna? No, I don’t do that. What I do is walk up to the TV, whack it a couple of times, and twist the aerial. What am I doing? I’m operating totally on feedback. I have never thought once about what is really going on. All I do is twist the aerial until the picture looks like what I think it should—until I see Mickey Mouse in all of his glory.
The market-making firms would make minor adjustments to the Black-Scholes model—the same way I twisted the aerial to get Mickey Mouse’s skin color to be beige instead of green—until their model showed the same prices that were being traded on the floor. Then they would say, “Wow, we solved it; here is the model!” They would use this model to print out option price sheets and send in a bunch of kids, whom we called “sheet monkeys,” to stand on the floor and make markets. But did they ever stop to think about what the right model would be instead of Black-Scholes?” No. They merely twisted the aerial on the TV set until the picture matched the picture on the floor.
This approach may be okay if you are a market maker and all you are trying to do is profit from the price spread between the bid and the offer rather than make statements about which options are fundamentally overpriced or underpriced. As a trader, however, I’m trying to put on positions that identify when the market is mispriced. I can’t use a model like that. I need to figure out fundamentally what the real prices should be, not to re-create the prices on the floor.
Even though you manage a quarter of a billion dollars you seem to keep an incredibly low profile. In fact, I’ve never seen your name in print. Is this deliberate?
As a policy, I don’t do interviews with the media.
Why is that?
My feeling is that it is very difficult for a money manager to give an honest interview. Why would I want to be interviewed and tell the world all my best investment ideas? Let’s say I am a fund manager and I have just identified XYZ as being the best buy around. Why should I go on TV and announce that to the world? If I really believe that is true, shouldn’t I be buying the stock? And if I am buying it, why would I want any competition?
Well, you may already be in the position.
Exactly. The only time anyone touts a position is when they have it on and want to get out. When you turn on some financial TV program and see someone tell you to buy a stock, there’s a good chance he’s telling you to buy what he wants to sell. I’ve seen fund managers recommend the stock on TV and then seen their sell orders on the floor the same day.
There is an alternative scenario. You could be bullish on XYZ and have just bought your entire position. If that is the case, it would be beneficial for you to have other people buying the stock, even if you have no intention of selling it.
Isn’t that also self-serving and unethical?
No, I would argue that if I own XYZ and want to get out of it, and then I go on TV to tout the stock—that is unethical. But if I have just bought XYZ and own all I want, and I am a long-term investor who doesn’t intend to get out of the stock for another six to eight months, I don’t see anything wrong with recommending the stock.
Maybe not in that case. But being on the floor, I’ve seen all sorts of conflicts between trade recommendations and a firm’s own trading activity.
Such as?
I’ll give you an example that is a matter of public record and involves over-the-counter stocks—those total dens of thievery. It became recognized that some companies recommended stocks to their clients and then sold the same stocks themselves all day long. Not only were these firms the largest sellers of a stock on the day after they recommended it, but they were also the largest buyers of the stock during the preceding week. Here is how they explained it—I’m paraphrasing, but I am not making any of this up: “These over-the-counter stocks have very little liquidity. If we just recommend the stock, our clients won’t be able to buy it because the market will run away. Therefore we have a to buy a few million shares of the stock before we recommend it, so that when we do, we have supply to sell our customers.” The SEC, which looked into this practice, accepted their argument, and they continue to do this. It’s perfectly legal.
If you took the cynical attitude that all Wall Street recommendations are made to get the firm’s large clients or the firm itself out of positions, you would make money. I had a friend who made money using exactly that strategy. In my own trading, when I am estimating the price probability distribution for a stock, and a number of Wall Street firms put out buy recommendations on that stock, it grossly changes the probability distribution—the chances of that stock dropping sharply become much larger.
Why is that?
If a bunch of brokerage firms recommend AOL, after two or three weeks, we figure that everyone who wanted to buy the stock has already bought it. That’s the same reason why most fund managers underperform the S&P: They buy the trendy stocks and the stocks where all the good news is. The fact is that they may be buying a good company, but they’re getting it at a bad price. Conversely, when a stock gets hit by really bad news, and every analyst downgrades the stock, it’s probably a good buy. It may be a bad company, but you are getting a good price—not necessarily right away, but after a few weeks when all the selling on the news has taken place. It’s not the current opinion on the stock that matters, but rather the potential change in the opinion.
It doesn’t sound like you have a very high regard for Wall Street analysts.
If you tune in CNBC and see a stock that has announced horrendous earnings and is down 40 percent, the next morning, you’ll see every analyst on the Street dropping the stock from their recommended list. Where were they the day before? Even though the news is already out and the stock is down 40 percent in after-hours trading, they get credit for recommending liquidation of the stock on the previous day’s close because the market hasn’t officially opened yet. When you look at their track record, it appears that they recommended liquidating the stock at $50, even though at the time, the stock was trading at $30 in the off-the-floor market before the official exchange opening. Conversely, if a stock announces good news, and the stock is trading sharply higher before the official exchange opening, analysts can recommend a buy and get credit for issuing the recommendation on the previous close.
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Bender provides some very important insights for option traders, and we’ll get to those in a moment. But the most important message of this chapter is: Don’t accept anything; question everything. This principle is equally relevant to all traders, and I suspect to all professions. The breakthroughs are made by those that question what is obviously “true.” As but one example, before Einstein, the idea that time was a constant seemed so apparent that the alternative was not even considered. By questioning the obvious and realizing that the accepted view had to be wrong (that is, time was variable and dependent on relative velocity), Einstein made the greatest strides in the history of science.
One of the basic tenets of option theory is that the probabilities of different prices on a future date
can be described by a normal curve.* Many traders have tweaked this model in various ways. For example, many option market participants have realized that rare events (very large price increases and decreases, such as the October 19, 1987, stock market crash) were far more common in reality than predicted by a normal curve and have adjusted the curve accordingly. (They made the tails of the curve fatter.) Bender, however, has gone much further. He has questioned the very premise of using a normal curve as the starting point for describing prices. He has also questioned the convention of using a single model to describe the price behavior—and by implication option prices—of different markets and stocks. By ditching the concept that price movements behave in the random fashion implicitly assumed by a normal distribution and by dropping the assumption of a universal model, Bender was able to derive much more accurate option pricing models.
Ideally, options should be used to express trades where the trader’s expectations differ from the theoretical assumptions of standard option pricing models. For example, if you believe that a given stock has a chance that is much greater than normal of witnessing a large, rapid price rise before the option expiration date, then purchasing out-of-the-money call options might be a much better trade (in terms of return versus risk) than buying the stock. (Out-of-the-money call options are relatively cheap because they will only have value at expiration if the stock price rises sharply.)
As another example, let’s say there is an upcoming event for a stock that has an equal chance of being bullish or bearish. But if it is bullish, you expect that a large price rise will be more likely than a moderate price rise. Standard option pricing models, of course, assume that a moderate price rise is always more likely than a large price rise. Insofar as your assumptions are correct and not already discounted by prevailing option prices, it would be possible to construct an option trade that would stack the odds in your favor. As one example, you might sell at-the-money call options and use the premium collected to buy a much larger number of cheaper out-of-the-money call options. This strategy will break even if prices decline, lose moderately if prices rise a little, and win big if prices rise a lot.
The key to using options effectively is to sketch out your expectations of the probabilities of a stock moving to different price levels. If these expectations differ from the neutral price assumptions that underlie a normal distribution curve and standard option pricing models, it implies that there are option strategies that offer a particularly favorable bet—assuming, of course, that your expectations tend to be more accurate than random guesses.
* * *
Update on John Bender
Bender closed his fund in late 2000, a consequence of a brain aneurysm he suffered earlier in the year. While the stock markets plunged in 2000 (declines of 10 percent in the S&P 500 and 39 percent in Nasdaq), his fund registered an astonishing 269 percent return.
Since closing his fund, Bender has devoted his energies to preserving the Costa Rican rain forest. Bender has used his market winnings to establish a reserve in which he has accumulated ownership of over 5,000 acres. Bender is thrilled that there are already indications of a marked recovery in animal numbers on the reserve. Speaking of poachers, he explains, “Since our land is patrolled and there is land fifty miles away that isn’t, they go there.” Next, he is planning to reintroduce near-extinct wildlife species into the preserve. Bender’s desire to expand the reserve is a primary reason he is considering resuming his trading career, albeit at a much less frenzied pace.
I don’t want to ask questions that are too personal, but I don’t know how to avoid the subject. Just tell me if you feel uncomfortable talking about it. Did the aneurysm occur while you were trading?
Ironically, it occurred while I was on a long weekend vacation in Costa Rica. At the time, I thought that was kind of weird. I subsequently found out that it is more common for aneurysms to occur when there is a break from high stress than during a period of stress. For example, it is much more common for aneurysms to occur on a weekend than during a weekday.
I know your fund closed a little over a half year after you suffered your aneurysm. Did you recover quickly enough to have any involvement with the fund before it closed, or did your staff just gradually liquidate the positions?
Actually, I was back to watching the markets and supervising the portfolio in terms of risk management within about a month. I wasn’t that active in trading, though, because I had speech problems. I couldn’t pick up the phone and place an order because it would have been impossible for someone to understand me, and even if I could be understood, I was embarrassed by my speech. I could, however, relay important information to my wife, Ann, who could then relay the message to the appropriate people.
Given the seriousness of your medical condition, why did you return to such stressful activity so quickly?
The fund held huge positions. I felt an obligation to my investors to watch those positions so that they could be closed down in an orderly fashion. As it turned out, during the period before the fund closed—the second and third quarters of 2000—a lot of the events I had anticipated would happen in the markets occurred, and the fund made a huge amount of money.
Was the aneurysm the reason you gave up trading?
It was certainly a wake-up call that my lifestyle had degraded to a point where something had to change. I realized that trading twenty hours a day and sleeping two hours during weekdays was not a sustainable schedule. I also had a friend who was a trader and had just suffered a heart attack at forty-one. Another very important influence was my growing involvement in preserving the Costa Rican rain forest. I felt I wanted to devote my life to the preserve. All of these factors contributed to my decision to quit trading.
Did you view this as a permanent exit or did you expect to return to trading at some future point?
If you asked me at the time, I would have said I probably wouldn’t come back. But that would have been my best guess; I didn’t know for sure.
Have you begun trading again?
No, but I did start watching the market seriously several weeks ago. If I do resume trading, it will be on a limited basis, trading only in the U.S. time zone, not the twenty-hour days I was doing before.
We’ve seen a dramatic slide in stock prices since our original interview. Any thoughts about this situation?
I don’t want to come off sounding too high and mighty, but this is what I thought would happen when we did our interview.
Namely?
Namely what Warren Buffett has been saying all along: The widespread adoption of a new technology doesn’t mean that anyone is going to make a profit. As he points out, most airline companies failed, even though the airplane was a wonderful invention, which lots of people use. Similarly, most car manufacturers also failed, even though almost everyone uses cars. During the late stages of the bull market, you had all these people running around saying that the Internet was going to change the world, and therefore you had to invest. Well, yes the Internet will change the world, but that doesn’t mean it’s a good investment.
There was also the distortion of the positive feedback loop—higher Internet stock prices influenced more buying of Internet stocks, causing still higher prices and so on. This can only go on for so long before a negative feedback develops. Consider what happened with IPOs during the latter stages of the bull market. Companies with $10 million of computer equipment and an idea that had no barrier to entry were selling at capitalizations of $4 billion. The day when somebody pays billions for a company that takes millions to set up is the day you are going to see twenty smart people start twenty more companies that look exactly the same. And that is precisely what happened.
It’s obvious that the combination of wildly inflated stock prices and the absence of barriers to entry had striking bearish implications for Internet companies. But why would the Internet be bearish for other companies?
Because the Internet lowers the barriers to entry into a huge range of different busin
esses. Unless there is intellectual property involved, your competition is endless. Anyone can now put up a web site for minimal cost and sell the same products as established companies with lots of infrastructure. They don’t need a marketing department; they can use the Internet. They don’t need a distribution center; they can use UPS. The Internet also makes it easier for consumers to do searches and buy on price comparisons. Unless you are producing an item that involves intellectual property, I would argue that eventually you are going to see your profits go to zero.
Are you still bearish now with stock prices having already declined very sharply from their 2000 highs? What is your long-term view for the market at this juncture?
Have we reached a correct valuation for stocks compared with other bear market lows? No, but I don’t think this bear market will end in the usual way with stock prices falling to extreme low valuation levels as is typical at market bottoms. There is just too much money available for investment for that to happen. It’s a demographic argument. We are at the threshold of a time period when the baby boomers will be at their peak earning years. At the same time, their expenses will be declining, as more of their mortgages are paid off and their kids get out of college or leave the household. This combination of trends will create a huge pool of money that needs to be invested somewhere. A lot of people right now are willing to let their money sit in cash because they’re scared. But cash investments are paying almost nothing. It won’t take much to sway people to start putting money back into stocks because the alternative implies almost no return.
* * *
DAVID SHAW
The Quantitative Edge
In offices situated on the upper floors of a midtown Manhattan skyscraper, Shaw has assembled scores of the country’s most brilliant mathematicians, physicists, and computer scientists with one purpose in mind: to combine their quantitative skills to consistently extract profits from the world’s financial markets. Employing a myriad of interrelated, complex mathematical models, the firm, D. E. Shaw, trades thousands of stocks in more than ten countries, as well as financial instruments linked to these stock markets (warrants, options, and convertible bonds). The company seeks to profit strictly from pricing discrepancies among different securities, rigorously avoiding risks associated with directional moves in the stock market or other financial markets (currencies and interest rates).
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