A Canadian on Wall Street

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.”

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.

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.

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?

“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.

I’ve been trading options occasionally for several years, and it’s a tricky market. The small investor is preyed on by a slew of options trading seminars and “educational websites” that teach complicated and (due to commissions) expensive strategies — with some of the more exotic strategies, like condors and butterflies, you could be trying to yoke four different options together. And anyone who has traded options knows how illiquid they can be compared to equities, making those multi-option trades very difficult to pull off effectively.

In my opinion, LEAPS (Long Term Equity AnticiPation Security) are about the only derivative that I feel worth using. When you first start option trading, the front-month options with their bargain basement prices seem like the way to go — buy a stack of them ahead of an earnings call and wait for the surprise to make the option pop. In fact, that strategy — essentially, of buying very out of the money options, letting most expire worthless and occasionally winning big enough to compensate and profit on the few — is the strategy that a primary proponent of the inability to know anything about the future action of the markets, Nassim Nicholas Taleb, uses in his options trading. It’s not necessarily a bad strategy, but one that I find takes an incredibly strong stomach and one that can often see you losing a lot of money and doubting yourself when you haven’t made the big score. Sounds like gambling.

With LEAPS, there is still the possibility of losing the entire investment, like in any option that might expire worthless at expiration. But what I like about LEAPS is that you are able to make time more of an ally — for most equities these days, a year or two is enough to see significant change in market value (unless, and this is quite possible, you choose an underlying stock that remains stagnant — there’s no perfect strategy in investing), and there is a definite exit time for the strategy. Although you won’t lose your investment in a stock, it’s quite possible that you will see the same loss and yet continue to hold on to that position while you wait for it to return to breakeven. Unless you specifically invested in that stock with the intention to hold it indefinitely, I view that as a bad trait of an active investor — being anchored to a position when that capital that is locked up can be deployed elsewhere. The freer your capital, the better off you are.

I have a two-fold reason for starting this site: one, I’m tired of the America-centrism that exists in most investment blogs, since most of them are based in the United States. And two, I’m a natural cynic and anti-evangelist and I feel this perspective on investing is not as present as it should be online (or even in the real world). Everyone thinks that there’s an effective system out there that just needs to be discovered, often through “technical” or “fundamental” means, as if these two terms can bring some form of empiricism to what at heart is a slowed-down form of intelligent gambling. The first trucks in colourful graphs and arbitrary rule-systems, while the second ascribes implicit value to companies, when value is solely the agreed upon price of a populace. Gold investors never seem to remember this, or fall back on the old “humans have always valued gold.” Always? Really?

Anyhow, as you can plainly tell already, I’m not much of a believer. Why do I invest? For various reasons: a chance to make money, a gambling arena that has no real house edge, an intellectual pursuit with no real solution. Maybe it just tickles my fancy when the numbers go up — entertainment? After a good seven years market-watching and reading and thinking about companies, I’m as willing to go with an experienced hunch and an adaptable attitude toward my investments (Rule No. 1, which I will continue to expound in the days ahead: Learn to Sell) as I am with some carefully calculated strategy that ultimately fails when some factor remains unaccounted for. It’s busywork, and can only help you so far before you just have to open your eyes and survey the scene.

With that said, my intention here is not to recommend companies’ stocks or educate the newbie investor. I will write about companies that I am thinking about and perhaps write about larger macroeconomic trends (although I’m not much of a macro-ist, frankly — I think of investing in this way as much like burning down a forest to kill a tree. Hmm, think I’ll need a better analogy than that!). I doubt I will describe my portfolio or its results, mainly because I think that if you do begin to do that, unless you are completely transparent about your results, that it is easy to become a shill for yourself — letting people know your best trades, or just the percentage but not the sizing. It’s natural for a lot of people to want to shine their shiniest shoes when they go out. I take the opposite tack, and usually obsess over my mistakes, but in either case, it’s never an accurate reflection of a person’s investing ability and tends to turn most investment blogs into de facto newsletters. So I will endeavour to be as objective as I can be and admit when I can’t be.

I will also admit to not being an expert on any stock, even the ones that fall into my career of technology. No one can be, even many of the employees of the company. Everyone who buys and sells stocks curries to certain favourite elements of a stock, and neglects other parts, so while I don’t have a complete and detailed view of GM, I do have an opinion on it and have acted on that opinion in the past — I don’t think anyone who really thinks about it can believe there are people who are experts on a stock. There are just people with more or less information, and in a strange twist, I think sometimes too much information can cause problems, too. There’s a delicate balance there, one which makes me think that investing still falls closer to the realm of art, ultimately.

So, dear reader, watch this space!