not sure whether you have actually said anything in this post. Volatility cannot be reliably predicted, period. All you can do is build models that show relative mispricings in assets and trade one versus the others. Its far from arbitrate as a lot of direct and residual risks remain. History repeats itself but in ever changing lengths and velocity of cycles. Thats why there are very few proprietary pure vol traders who have scored big but a number of heavy hitting sell-side market making vol traders. Not sure what benefit all that quant lingo serves, but I have market-made exotic rate derivs, market made swaptions, then later traded index and single stock vol prop, it always comes down to the same: On the market making side "know ya relative mispricings and flow", on the prop side "know the dynamics of the underlying in and out". I have not seen how any, no matter how sophisticated, french vol models ever guaranteed a dime trading vol on the prop side.
Valid points... However, I believe that volatility expansion/contraction can be predictive (the second derivative). You may disagree - which is fair, but that is not to say it is not possible. I am certaintly not saying we can tell you if it is going up or down and by how much - we are looking at it as a measure of mass and the 3 derivatives or motion. The point is - that an options price is a predictive implied value of the statical significance of the underlying. Simply put - the Straddle price is assuming an aprox 1 SD. That is predicitive - you either think it is undervalued or overvalued. Thus - one needs to be predicitive in their volatility assumption before buy/selling any premium. As you point out mispricing is based on either the difference (which is usually the case) - as with Timberhill's market making model and most market making OR the other route is against a baseline propritary model (this has to be predictive by its very nature). Market Makers act as a book maker - trading mispricing between the products. They move the line base on either order flow or expected flow - and their ability or inability to hedge that flow. Market Makers are (by their definition) not predictive in nature (just like a book maker). No Flow - No Money. Market making has to assume mark price and thus volatility is already defined for the market maker - it is right there on the screen. They are just looking to capture the mis-pricing not to determine if it is high or low vs. the statical volatilty. So for those that are not market making - one needs to make some level of predicition either delta and/or volatility. Any trade, by it's definition, assumes that prediction. There are many flaws with the existing models, no doubt. Delta-neutral trading fails consistantly by the very nature of the model's short-falls. There are better models for better resolution - but they all work on the same principal. Also - you either assume that stocks move in a random walk or you don't. I don't assume a normal distribution random walk - and that in itself can be a long winded argument - which I don't care to go down. This is already a longwinded post and if you sat in our offices - these discussions go on for hours. I am certainly a realist - have traded for 20 years and made markets. I have made huge blunders and many mistakes. I certainly know the limitations of existing models - but that should not keep me from trying to push the envelope in approaching the problem differently. I do enjoy picking the low-hanging fruit as you correctly pointed out, arbitrage and or mis-pricing cut/n/dry math trades. However, I do feel there is a missing link. Simple reason - Dice were used for over 200 years before people understood probability - think about how that changed the game. It wasn't to long ago when market makers didn't understand the concept of skew or even simpler conv/rev arbitrage or boxes/jelly rolls. Not saying that we will ever achieve our objective, but we will have fun trying - and who knows - it may reveal some other arbitrage opportunity that we didn't previously see. Now I need to go check on that cat, he has been in the box a while. I think he is fine (wink wink).
No - They invented them (sort of). I hadn't been on since 2006... I know of a couple of ex-timber hill traders that post on here and a few other market makers ... someone forwarded me a link to an interesting thread - so I decided to lurk and make a couple posts. However, I got the beat down (not trying to take a jab at your screen name) in one thread over a semantics issue when I was trying to help someone with the math. I quickly realized why I stop reading/posting to forums where people are more interested in the minutia and flames than actually being constructive. Oh well - live an learn. You never know - sometimes you find a diamond in the rough in the oddest places. By the way - the cat is fine - for now.
There are a lot of ways of parsing the term "resolution"... I'd be interested in understanding in what context you're using it here? I understood and agree with most of what you've posted here. The only part that sounds a little mumbo-jumbo and forced is the concept of "anti-volatility"; are you just referring to volatility moving between different regimes?
I was trying to compare the volatility to matter, when using the term "anti-volatility". Didn't mean to make is sound confusing. We are using some physics models to measure motion, I guess that is no different (in some respects, to Black-Scholes) Techincally - measuring volatility moving between different states.
I don't mean to be nit-picky, but that seems like incredibly confusing use of terminology to me. Yes, motion is physics. Yes, matter and anti-matter is physics. No, I really have absolutely idea how the two are remotely related to each other. Does volatility meeting anti-volatility release energy? I'm a little confused. Or are you just referring to some kind of regime switching system, for looking at volatility? Just eyeballing statistical volatility, it seems likely that would make sense. It also makes sense from a behavioral point of view. Funds are probably putting on/taking off volatility-based hedges based on obvious macros events.
Fully understand where you are coming from - it makes sense to me because we have been talking about it in those terms and one of our bean-bag fillers has a PhD in Physics - so he uses analogies (which I guess I have become use to hearing). Let me put it this way - it's a measurement of how much statistical volatility we expect will be released back into the market that is currently not being accounted for. Options use similar math terms and properties in physics (delta, gamma, etc.). We are looking to measure the amount of jerk, acceleration, and velocity we expect from the injection of a finite amount of volatility (a figure we have pre-determine) coming back into the market at any given moment. Hope that makes a little more sense. The magic question - how does it make you money? It is used to determine current option prices to create strategies based on the statitistical expectations. In the most simpiliest of terms - should I buy or sell the straddle and when?
I still think you dont make any sense at all, at least to me. Having traded index, single stock, and rates options prop and as market maker I have come across a number models and I claim I understood every single of them but I have no idea what you actually try to explain. *** what is "jerk" in options? *** anything about financial assets is finite and discrete so whats the surprise here. While a stock price has no upper bound it does not go up limitless. To each level a finite probability measure can be attached, whether to the underlying price or the volatility of the underlying. *** how do you "pre-determine" the amount of volatility that is "coming back" into the market? Isnt that the whole point, that the amount of vol change, the vol of vol, is as much a random variable that must be estimated as the direction of the vol? I am not saying that all those variables undergo the same stochastic process but all of them contain random variables and need to be treated differently if you even attempt to assign probability measures to them.
A quote from Filthy's excellent book on Vol Trading: "The worst econophysics is done by physicists who have mastery of some technique and are determined to somehow apply it to finance (every problem is a nail if your only technique is a hammer)."