Jimmy Cliff and Jimmy Wales

Been researching the derivatives industry a bit. It's pretty hard to find real deal professionals amongst all the get-rich-quick schemes online, but on a hunch I went hunting for some history on Jimmy Wales, one of the founders of Wikipedia and its primary early funding source. I ended up finding out that he was a prolific poster on the newsgroups from 1996-1998 and spent a ton of time in the objectivism newsgroups, which maybe is a little suspect, and strangely, in misc.invest.financial-plan, as opposed to the more esoteric newsgroups related to mathematical finance.

Here's one of the few posts related to his former career. It's not particularly new to me, as I did know a fair bit about the advantage market makers and pros have in the derivatives market, with their minuscule transactional costs. I think if more people knew that, the less willing they'd be to subscribe to seminars and schemes, aside from all the other equipment and know-how that people employ. That said, options trading is the ultimate in model-based, quantitative, theoretical trading, and so it still feels a little weird to me. Going in with my limited means, buying or selling a few puts or calls here at random -- am I a David versus Goliaths? It's hard to say, and it depends a lot on whether you think 1. the market is biased towards professionals and member firms and institutions and 2. that prognostication can be done mathematically -- something I'm still very doubtful of, not because of the math, but because of the prognostication. So knowing that prognostication is not possible, the only wait to defend against unexpected events is to be less exposed, as a portion of your portfolio. Cash management, bla bla.

(For interesting reference, here is one of the few derivatives related things that Wales recommends reading on the newsgroups, Don M. Chance's Derivatives 'R Us postings.)

I think another interesting thing that I took away from all this is that options trading firms typically seem to be this maverick organizations, since the equity requirements to be a member of the Chicago Board is 200 grand. Well, and a lot of other paperwork I think, but overall there isn't that kind of regulation that you see in stocks and bonds, and I think options trading houses tend to be even more out there than hedge funds, which tend to service clients and less inclined to the actions of the proprietary trading houses since they're dealing with client money. Or maybe it's the other way around?

CAPM illusions

Here's a succinct statement, attribute it to E. Derman:

If you can diversify over a large
enough M-neutral portfolio of stocks so
that their accumulated unavoidable risk
cancels, then this M-neutral portfolio of
zero volatility must earn the risk-free rate
r. The same must therefore be true of each
M-neutral element of the portfolio. This
leads to the result that:

(u - r) = β(uM - r)

This is the result of the capital asset
pricing model or arbitrage pricing theory:
in a world of rational investors, the excess
return you can expect from buying
a stock is its β times the expected return
of its hedgeable factor. Put differently, you
can only expect to be rewarded for the
unavoidable factor risk of each stock,
since all other risk can be eliminated by
diversification.

Notice that assumption: "if you can diversify over a large enough..." Not only is the rationalist methodology employed to derive this a little shaky, there's still that additional caveat that you have to diversify over a "large enough...portfolio". I'm sure there's some bit I don't know, where at a certain level of diversification you decrease the "risk" to a certain livable amount, so you don't have to be perfectly diversified, but yeah, still seems like a lot of conditionals.

It's a tough thing, trying to make money this way. It's even tougher with the overlay of being conscious of the possibility of pure randomness, and the possibility that skill doesn't exist. The hedge fund rebuttal guy described here doesn't seem to really know that, though, he'll tell you that the top hedge fund guys are just goddamn masters of their game. Modern celebrity kind of hews to the weird logic of hedge funds, too, with certain specific people taking off -- would hedge fund guy claim that Britney Spears was a skillful singer that didn't somehow get swept along in the fickle interest of the public? How would we know? The idea that luck (in the form of randomness) outruns skill every day of the week is something that more people have to be aware of.

Things I've been thinking about

"Liquid" is essentially synonymous with "popular" -- possibly why I'm sure there exist secretive, quant-run hedge funds that focus on using their models for liquid securities on the markets for illiquid versions (cf. Emanuel Derman). They can get a "fair value" and determine what kind of arbitrage exists in markets that are unpopular, where there are not enough people to guarantee that every instrument is fairly priced in an un-tradable time frame.

Starting to curry to Nassim Nicholas Taleb's writing again. I had skimmed his book something like six or eight months back but failed to appreciate how closely aligned his world view is with mine. Or the fact that so many other historical figures have come to the same conclusion: you can't predict the future using the past. It just occurred to me wonder what NNT thinks about Santayana: "Those who cannot remember the past are condemned to repeat it." Of course, history is never perfectly repeated, but we can develop lore and instinct from these past interactions, which is something I think NNT does agree with -- empirical (experiential) observations are where we should be looking. So I guess instead of simply "you can't predict the future using the past," we should add to that "but we can keep an eye on it." Predictability implies future knowledge and that is something we don't have, but certainly there are particular arrangements of preceding factors that may (BUT NOT DEFINITIVELY) give rise to similar future results.

I like quantitative finance for the admission that probability is a huge factor in markets, which is something completely missing from the "campfire story" tenets of "technical" trading. I do have to heed NNT's view that the Gaussian probability distribution probably is not the best way to understand a market that has numerous blow-ups (and if the Mandelbrotian fractal power law distribution or whatever is more applicable, what does that say about the size of some possible future blow-up? We ain't seen nothing yet...?). Is there any way to realistically account for these kinds of things? Taleb would buy huge numbers of OTM options (calls I think? Maybe both sides) with the idea that the view rare events that put him in the money were less rare than people thought, although it's not clear to me how that strategy worked out -- talk of that is conspicuously hard to find.