Option Pricing Models

Some models are wrong in a trivial way. They clearly just don’t agree with real financial markets. For example, an option valuation model that includes the return of the underlying as a pricing input is trivially wrong. This can be deduced from put-call parity. Imagine a stock that has a positive return. Naively, this will raise the value of calls and lower the value of puts. But put-call parity means that if calls increase, so do the value of the puts. Including drift leads to a contradiction. That idea is trivially wrong.

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More on Learning

Learning is hard. Sometimes it is hard in a trivial way. It can be hard because the subject matter is hard. Quantum field theory is a difficult subject and it is understandable that learning it won't be easy. However, learning is also hard for a more concerning reason. Humans don't change their opinions when confronted with facts, even when they directly contradict the opinion. 

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Learning

Effective learning from experience requires two things: practice and feedback. In trading we can’t do a great deal about the frequency of trading (practice) but we can make sure the feedback we get from our trades is relevant and valuable.

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Risk, Probability and Psychology

This is part II in our series of how to understand and manage risk in trading.

“Risk depends on the skills of a specific trader and is all of the things outside our control. So traders with different sources of edge will have different remaining risk factors. If I have an edge in volatility prediction and you don't, volatility is my edge and your risk. This is true in most of life. For a heart surgeon, doing a bypass is a low risk operation. For me, it would be murder.”

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Means, Medians and Mistakes

The difference between mean and median is known by anyone with a high school education. But a lot of traders, particularly option traders, seem to misunderstand what it means in practice. Any trade with edge needs to have a positive expected value, which is the mean return. Unfortunately, if your trade has highly skewed returns you are much more likely to observe a median value than a mean value.

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Perspectives on Risk

This is part I in our series of how to understand and manage risk in trading.

“It is the focus on risk that separates good investors from poor ones. No matter how good your edge is, if you go bankrupt through poor risk control you won't be able to capture the money. Successful trading is a long term game. “

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The Carry Trade: Benefits and Risks

I've gone from thinking that categorizing strategies was useful to thinking it is essential. Dividing trades into inefficiencies or risk premia helps when deciding how aggressive to be in sizing and also how suspicious to be about its decay in effectiveness. I've found the model based or situational dichotomy helpful with sizing decisions. 

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