Saturday, May 2, 2015

No Evergreen Investment Strategies

It looks like the Derivatives Strategy magazine archives are gone - and with them, the Derivatives Comix that were absolutely wonderful. I had saved excerpts from three stories from back issues which, together, illustrate perfectly a point that I've made before: there are no evergreen investment strategies that will always work, and the market has been becoming more efficient over time.

One was from a 2000 issue, about how options marketmaking worked [dead link].

"Xilinx is flying. AMAT is collapsing. Foundry is up huge. These stocks are all over the place. That's how I know they're all worth nothing."

A broker-dealer comes in and sells Riley 100 December '01 calls on Nextel. "He may know something is going on, and back-dated options are dangerous,” says Riley. "I'm going to push my back-dated volatilities down a bit.” His fingers madly push at various toggle adjustments on the XTOPS system. December '01 Nextel option prices are suddenly all 1/8 to 1/4 lower than they were a few seconds ago.
Note that excellent point about volatility ~ lack of intrinsic value. Second story, from 1995-1996 [dead link].
The guy who first had the opportunity to make a lot of money doing this was Mark Rich. How did it work? I buy options. I go to this bright young dealer. He's got his options pricing model, and I want to buy a call. He gives me the price because he's got a model and he figures they're liquid instruments, and he can always buy more and more to complete the hedge.

But I'm the gorilla. So I can buy a lot of options from him and from other dealers just like him. I know one thing. Every time I buy more, it sets off a signal to buy more. It's a positive feedback loop. I'm the gorilla. I can control you. I can eventually make you buy a lot of it. If I can control the marketplace to make you buy more of it, I can dominate you because I know your recipe for replicating the options.
Third story, from 1998 issue [dead link].
But as Susquehanna has found over the years, the markets change and an interesting arbitrage technique can easily be annihilated. "Before the crash of 1987, we just ‘arbed' volatility from one strike to another,” says Yass. "But after everyone started using the Black-Scholes model, the questions became, What is the skew? What is the distribution? The next frontier is correlations.” But after that? "Who knows,” laughs Yass.
True arbitrages get harder to find. There was a time when the marketplace was full of options (stock options, convertible debt) but no general theory for pricing them.

There are no evergreen investment strategies that will always work. By the time an investment approach becomes part of the landscape, the people who were using it have generally gathered assets and are rich, fat, and lazy. The 80 year old fund managers who made it big 50 years ago by being the first people to get copies of filings dropped off at the SEC offices (once a great edge!) are not hungry enough to develop tomorrow's cutting-edge technique. This is why every generation or so there is a New School of investing that displaces the old, like succession in an ecosystem.


Jason DaCruz said...

Those seem interesting, and I'm disappointed to be hearing about them so late. Is there a way to get archive copies of some of these articles?

CP said...

It would be nice to find paper copies, but I haven't seen any.

It had a comic strip called Derivatives Comix that was unbelievable. Really well drawn and witty.

I can't believe there's no archive of this anywhere.

CP said...

CP said...

There's a google cache of a lot of the Comix: