Stochastic process for irrational stocks

Discussion in 'Options' started by ajensen, Jan 27, 2021.

  1. ajensen

    ajensen

    Stock prices are commonly modeled as a geometric Brownian motion to value stock options, as in the Black-Scholes model. How do you model a stock price where market price is temporarily disconnected from the fundamental value and is far more volatile than it? You can write

    S(t) = z(t)*s(t)

    where S(t) is the market price, s(t) is the fundamental value (FV), and z(t) is ratio of stock price to FV, which is mean-reverting around 1. You can model s(t) as a GBM and log z(t) as a mean-reverting process. Has this kind of model been studied? Of course, the problem with shorting a stock such as GME is that margin clerks look at S(t), not s(t) when deciding whether to liquidate your positions.

    Hmm, before posting, I did a literature search and found a paper

    Permanent and Temporary Components of Stock Prices
    Eugene F. Fama and Kenneth R. French
    Journal of Political Economy
    Vol. 96, No. 2 (Apr., 1988), pp. 246-273 (28 pages)

    with this model. I'll read it.
     
  2. 2rosy

    2rosy

    try jump diffusion
     
  3. MrMuppet

    MrMuppet

    Simple: You sit down, write your model on a piece of paper and throw that into the waste bin.

    Then you fire up your trading machine, open an orderbook, a time&sales, an option chain, twitter and reddit and start clicking.

    Trying to model something with no data from the past doesn't make any sense. There is a gammut of variables that you don't even know they could play a role in this case. Government actions, rule changes, halts, etc.

    In these cases you either are a good trader or you stay on the sidelines and watch.
     
    Atikon, .sigma and guru like this.
  4. traider

    traider

    HFT does fine with its models. Are you really sure that this chaos can be defined by a neat math equation ?
     
  5. MrMuppet

    MrMuppet

    HFT is fine when it arbs latency or frontruns retail flow. Option MMs have vega convexity to lean on but you can be sure that stat arbs are getting killed.
     
    Atikon and Tony Optionaro like this.