The Short-Timers

March 28, 2008

In this volatile market, where making outsized gains is fairly unlikely, I’ve started to appreciate more the features of options. In addition to the usual pro of leverage, there’s a natural stop-loss built in to any contract (i.e. the total value of the contracts and commission is the maximum you can lose) that becomes more attractive in a market where it’s unlikely that major advances will be made. As well, what is usually considered a disadvantage of options — their definite expiration — is in fact an advantage in the current markets: it forces you to think about specific events that might occur and to buy appropriate contracts to, hopefully, profit from these events, and removes the hazy, undefined expectations that have no time frame and can cause you to stay in positions that you have no definite reason to. (On a side note, prediction markets are more closely aligned with options than futures in my mind due to their loss limitation features; I think using options in the way you might use the prediction market contracts, i.e. with at least some awareness of probabilities, is a fairly good method — has someone explored this?)

That said, obviously owning a stock has its own advantages — possibly dividends, more liquidity and if your cost basis is low enough and the business is strong over time, the time frame to pick and choose when you want to sell — but for the time being I’ve preferred option trades.

No Comments » | Investing Philosophy, Options | Permalink
Posted by Nelson Yee

What you putting down?

March 14, 2008

BSC APR08 60 PUT

I had been monitoring this option and considering this trade since about Tuesday, when they first spiked on nervousness about Bear Stearns’ (BSC) liquidity. Can’t count money you didn’t make, I guess, but there’s always another trade. I love how no one bought the stuff Alan Schwartz was selling at all and in the end he basically did an about-face.

No Comments » | Options | Permalink
Posted by Nelson Yee

A spoonful of patience is worth a pound of prescience

February 8, 2008

Actually, that title isn’t that accurate, but it sounds nice, and that’s we care about here. Obviously if we could predict the future with any accuracy, patience wouldn’t even factor in. As it stands, though, the ability to temper the natural traits of human nature is the number one priority in investing, as far as I’m concerned. I look to myself as an example of this — for the past several years my investing has been poor in the face of what, relative to the days of 2002 to 2004, is a fairly volatile market. It’s incredibly hard to stick to strategies that take ages to develop a significant margin of profit or loss, so decisive action is difficult to make.

Most recently, I made a decent profit on a front-month option play derived from an underlying stock that has had a lot of news associated with it. But the longer I held the paper profit, the more anxious I got over dips that would cut it back. There was no reason NOT to let it expire in the money, and with the lack of news, the volume was not there for significant selling. But for some odd reason I got antsy, as I do sometimes, and sold out poorly — at market price, of all things! — and though I took a profit it was soured by the poor exit that I made. Since then, more news has come out to fuel the underlying and I left a significant amount on the table — instead of a 100% return, I coulda shoulda woulda made a 300% return. Obviously this is a common regret for investors, and something that must be tempered if one is to continue investing (the natural instinct is to go back in to the same position, at a much less attractive price, much the same way people follow mutual funds that have had banner years, only to discover the fund underperforming after they put their money in). It does highlight how useful it is to be a good gambler. Poker may be the closest of the card games to the financial markets, with its multiple player psychologies/strategies and incomplete knowledge, but a lot of the techniques of gambling, like bankroll management and the ability to recognize one’s own emotional responses to success or failure and control them, are present in any form of game where money is at risk.

I guess this is just my attempt at catharsis for a newbie move. Whoever bought those options off me got a pretty nice deal.

No Comments » | Finance and Investing Links, Investing Philosophy, Options | Permalink
Posted by Nelson Yee

Emanuel Derman on stocks versus bonds

January 16, 2007

Funny, telling quote from Derman’s book My Life as a Quant:

Although options theory originated in the world of stocks, it is exploited more widely in the fixed-income universe. Stocks (at least at first glance) lack mathematical detail–if you own a share of stock you are guaranteed nothing; all you really know is that its price may go up or down. In contrast, fixed-income securities such as bonds are ornate mechanisms that promise to spin off future periodic payments of interest and a final return of principal. This specification of detail makes fixed income a much more numerate business than equities, and one much more amenable to mathematical analysis. Every fixed-income security–bonds, mortgages, convertible bonds, and swaps, to name only a few–has a value that it depends on, and is therefore conveniently viewed as a derivative of the market’s underlying interest rates. Interest-rate derivatives are naturally attractive products for corporations who, as part of their normal business, must borrow money by issuing bonds whose value changes when interest or exchange rates fluctuate. It is much more challenging to create realistic models of the movement of interest rates, which change in more complex ways than stock prices; interest-rate modeling has thus been the mother of invention in the theory of derivatives for the past twenty years. It is an area in which quants are ubiquitous.

In contrast, quants have been a rarer presence in the equity world. There, most investors are concerned with which stock to buy, a problem on which the advanced mathematics of derivatives can shed little light. Fixed income and equities have fundamentally different foci. When you walk around a frenetic fixed-income trading floor, you hear people shouting out numbers–yields and spreads–over the hoot-and-holler; on a busy equities floor, you mostly hear people shouting company names. Fixed-income trading requires a better grasp of technology and quantitative methods than equities trading. A trader friend of mine summed it up succinctly when, after I commented to him that the fixed-income traders I knew seemed smarter than the equity traders, he replied that “that’s because there’s no competitive edge to being smart in the equities business.” (ed: emphasis mine)

Or as Woody Allen recalled in his script for Match Point, “it’s better to be lucky than to be good.”

No Comments » | Financial Mathematics, Investing Philosophy, Options, Stocks | Permalink
Posted by Nelson Yee

Macleans Magazine on Banning Stock Options

January 15, 2007

There’s an interesting article in Macleans this month that lays out the case against stock options, specifically at the executive level. It’s too bad I can’t link this online, as it doesn’t seem to be on their website, but it makes the good point that options, even minus the backdating scandals that keep cropping up daily, are pretty ineffective for their purported goal of tying the compensation of executives to the performance of their company.

Along with the ability to “monetize” options by repricing them when the option goes underwater, options reward good performance but have no symmetrical ability to punish bad performance, so for most executives, it’s a nice lottery ticket in addition to their base salaries. Option accounting is itself a quagmire of estimation and approximation, and though we’ve now moved past some of the worst obfuscations in option accounting, it’s just one more obstacle to understanding a company. Furthermore, with the rise of the share buyback — a column in itself — executives can now manage their earnings quite well, aiding their ability to push a stock into a range where their options are in the money. Even when the cash put towards the buybacks, from the shareholder perspective, would be better redistributed as dividends, there has been a push to use the buyback mechanism because it is a quick way to decrease the shares outstanding and thus increase the earnings per share. Earnings per share has become a de facto measure for the average stock buyer to rate a stock based on the movements of the market, even though it’s highly manipulable.

Executive compensation has become a major axe ground by Warren Buffett and a host of shareholder-activists, and with good reason — the only people these things are benefiting are the executives. It doesn’t help companies, employees, shareholders or society at large when there are people with such an outsize share of the wealth.

2 Comments | Business, Interesting Articles, Options | Permalink
Posted by Nelson Yee

RIM - Dancing with the devil

January 11, 2007

With the amount of hoopla surrounding Apple’s foray into the smartphone market, and the subsequent hit to its potential new competitors, it’s got me thinking once again about shorting the only real Canadian contender in that arena, Research in Motion.

I have a friend who was burned quite badly by RIM in late 2003, around the time the stock was trading in the pre-split $45 dollar range. He had lulled himself into believing that the stock was predictable and that it moved in smooth gradations back and forth, and he profited from the minor ups and downs. Then, RIM did what it’s done quite a few times since, and announced the first of many monster quarters, where it defied all estimates. My friend had a massive, leveraged short on RIM at the time, not unlike many daytraders who try to maximize the reward (and also the risk, as in this case) gleaned from the small, everyday fluctuations of a stock, the fluctuations that Benjamin Graham always attributed to Mr. Market’s schizophrenic nature. That blew up his portfolio and taught me about RIM’s super volatility.

Still, in 2007 RIM does seem a touch pricey, but pricey enough to warrant a short, or a LEAP put? At a P/E of nearly 70, it’s certainly not a value stock, but they have a serious lock on the enterprise email segment through partnerships and being first-mover. (Or at least, first successful mover — Infowave was in the market at the same time but did not have the killer Blackberry hardware and a true “push” email link with Microsoft Exchange Server, the backend to the ubiquitous Outlook; I was an investor in IW and watched as my “value” purchase of the stock at around the $30 market, after a major fall from triple digits, turned into a literal (ha’)penny stock.) There was some news about competitors in the past, including Nokia, but I suspect it’s no longer strictly technology that can put a crimp in RIM’s hold on that market as much as better deal-making on the part of their competitors.

To keep their growth alive, RIM put out the Blackberry Pearl not that long ago, its great hope in the smartphone wars. It’s questionable to me how big the smartphone market is, though. Analysts bandy about numbers, but what it comes down to is whether or not the majority of people really want to have all-in-one devices. It seems strange to see us creeping back in on this concept of convergence which was so popular in the late 90s, but which died an ignominous death in the tech blow-up of 2000. The new iPhone (or whatever it may end up being called, if the Cisco lawsuit is more than sabre-rattling) is certainly a stylish addition to the space, but again, how many people want a combination camera, music player, cellphone, PDA? There’s a solid, hardcore gadget-fan population that will buy that kind of thing before they eat breakfast, but in terms of everyday use, most users will view that as overkill. How far does the Apple sheen go, anyhow? (Steve Jobs was also the guy behind NeXT, so it’s not like he’s completely infallible.) Will RIM’s solid but sort of pedestrian Pearl, with its current availability — a la the XBox 360 versus the PS3 — and cheaper price point, be affected as greatly as some people seem to think? And is the smartphone market as big as either of these players, RIM or Apple (or Motorola and Palm) seem to think? I suspect that there’s a kind of “smartphone aura” that’s injected a bubbly premium into these stocks.

With that said, though… who’s really brave enough to short RIM? My view of shorting, learned from some experience, is that it’s really not a great idea to short a company’s stock unless you think that company is going to go bankrupt or that it is so spectacularly mismanaged and problematic that it may as well. It helps, too, if the company is in a dying or dead industry, to add that extra oomph. Does RIM fall into that category? Not really, so for me I’d likely employ a long-term put if I wanted to participate in any “return to earth”, but even then I find RIM has been so completely unpredictable in the past that I’d rather just avoid it for now. Those folks who shorted RIM in early 2006 at $85 would have had a pretty hard time predicting that after all that patent litigation cleared up, the stock would climb as much as it did, and I’m sure more than just my friend’s shirt has been lost trying to tame this beast.

3 Comments | Investing Philosophy, Options, Sectors, Stocks | Permalink
Posted by Nelson Yee

Jimmy Cliff and Jimmy Wales

November 9, 2006

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?

No Comments » | Interesting Articles, Options | Permalink
Posted by Nelson Yee

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