Excellent!! So here we have a situation where we are betting on something that is completely random, and yet, by betting when we are paid to do so, when the odds are tilted our way, we have a positive expectancy. We don't predict anything. It is in the structure of the game itself that creates the edge. Ok, next question. Say we get 60:40 to flip a fair coin against someone. That is, if we win, we get .60 and if we lose we pay out .40. What is our expectancy over thousands (or any big number) of bet iterations? This leads to the Central Limit Theorem, the most important result in all of probability theory. Without being able to compute expectancy we get nowhere. nitro
Hi Jack, These questions are in positive reaction to your contribution to this thread. Could you lay out more on how your brain stem functions? (thought processes) Your levels of awareness?(knowing that you know, etc.) How do you approach negative emotions? What fuels the capacity of your output? Is it the emotion of 'caring'? Intellectual eureka statements? Food/diet? Other? Finally , what is your world view? Uber
Two observations. First, with a coin flip, the odds per flip and the expectancy of outcome over many trials are mathematically calculable with a high level of confidence. And we are assuming that flips of a fair coin are indeed truly random in respect of one another. However, I don't think that we can legitimately assume that all price moves are entirely independent of one another. People tend to act in groups (or herds) and setups are normally based on the preceding price action. They may conflict with one another, but I would hardly call them independent (random). But that's neither here nor there because we're talking about coin tosses rather than the markets. My second observation is that your coin toss analogy seems to be alluding to the idea that your edge (for lack of a better word) is based not so much on the observation of non-random price phenomena, but rather on the observation of mispriced options based on the assumption of random price action of the underlying. Personally, because I don't believe price action of the underlying is sufficiently random, I think that your premise is flawed. That is not to say that it won't necessarily work for you for a time. But I wouldn't be quite so confident in your options pricing model as I would be with your 60/40 coin toss analogy.
Do you have any evidence to support this claim? I would be interested. Also, what is "statistical proof"?
I am not making an assertion as to whether people act in herds or not, and whether you could gain information from noticing that they do. That was my whole point about asking the "wrong" question: it doesn't matter to many traders that are hugely profitable. In the hope of being more clear, I am making two statements: 1) Many if not most derivatives traders assume that the underlying follows a [Geometric] Brownian Motion, or said another way that the underlying is a random variable like a coin flip. Whether that is the truth or not is a philosophical question to derivatives traders. The way they make markets or compute theoretical prices completely ignores this philosophical question because the simplification of assuming a random variable and ignoring the philosophical question doesn't affect their profitability. 2) I stated that the question of trying to predict markets confused people into followig the wrong path to trading profitability. I tried to give an analogy by showing how you can make money playing games where the outcome of the event is random and therefore unpredictable by definition. While I do not claim that markets are coin tossing games, the insight gained from reducing the complexities of markets to simple games like these should not be underestimated. In fact, if you understand the mathematics of coin flips and expentancies etc, it is amazing how close you get to the way options prices are derived mathematically. I had to read this a couple of times to understand what you say I am saying, but I think you got it. I am saying that an option's price does not predict where the underlying goes. It says that given a volatility expectation for that option, I can compute it's fair price by plugging that value along with other less complex parameters into the Black Scholes model. The BS model then outputs the theoretical price. This theoretical price plays the same role as the 50:50 probability that we realize is true for a coin flip. It is the average price when all possible paths are computed and weighted according to probabilities. Same with the coin flip. We then make a market around that theo price, which is the edge we demand for making a market. If you fill where we make a market, it is like the coin toss game where we demand 60% if we win and we pay out 40% if we lose. Of course, on any one realization of this game, it may be 80:20 or 90:10 or whatever, but over many many trials and many many positions, that or somethig like it is our expectancy. Notice there is no prediction of the underlying whatsoever, and in fact we have no idea which trades will lose or win. Prediction is replaced by computation of fair price, and our edge is the spread we make around fair price, which we demand for taking the risk and providing liquidity. Nearly 100% of options market making firms do exactly this. It is hugely profitable and has been for decades. nitro
Yes, I understand that this is what you were alluding to. I'm just suggesting that the computation of "fair" price is probably less accurate than it appears, and certainly less accurate than the computation in connection with the coin toss. That is what I meant in the last sentence of my previous post. However, if the spread is sufficiently large, then I imagine that it typically overrides any such inaccuracies. But, hey, I'm in over my head here. I don't trade options and know next to nothing about them. Too many moving parts for the likes of me.
1 You can offer to be the dealer and charge the buyer and seller a commision. This role is filled by brokers. 2 You can offer to sell insurance to buyers and sellers so that they can 'hedge' their bets. Insurance sellers fill this role. 3 You can offer incorrect odds so long as you have the higher odds favor your position (what you've mentioned above). This role is filled by market makers. You still haven't explain how a trader/investor can profit. So you're basically saying all traders/investors should just be market makers.