The Heston Recipe

 Most traders are intimately familiar the implied volatilities of equity options. These implied volatilities are often smoothed to avoid the temporary spikes in the strike/maturity surface that can lead to butterfly and calendar arbitrage. Many trading desks and market makers use the Heston stochastic volatility model for smoothing.

To understand the genesis behind Heston model, and why it is so important, we must revisit an event that shook financial markets around the world: the stock market crash of October 1987. The consequence on the options market was an exacerbation of smiles and skews in the implied volatility surface which has persisted to this day. This brought into question the restrictive assumptions behind the Black-Scholes option pricing model, the most tenuous of which is that continuously compounded stock returns be normally distributed with constant volatility. A number of researchers since then have sought to eliminate the constant volatility assumption in their models, by allowing volatility to be time-varying. (more…)

Try to Learn these things

  1. Ancient Chinese philosophers realized that with great danger often comes great opportunity. This nexus is further reinforced by the fact that the Chinese character representing both danger and opportunity is the same. Remember that only those who possess and use the necessary skills to survive the period of great danger are in position to profit from great opportunity. Risk control is paramount.
  2. The extrinsic (time) component of the option premium goes to zero at options expiration. Always.
  3. Although statisticians would argue, the probability of occurrence of an extremely unlikely event is much greater if you “bet the farm” on the event not occurring. Never forget that black swans do exist.
  4. The human brain is not inherently logical. It evolved for survival and is prone to make erroneous assumptions and draw incorrect associations. To guard against these potentially costly errors, continuously challenge your assumptions.
  5. Absence of proof does not constitute proof of absence.
  6. Thinly traded options are usually characterized by egregious B/A spreads. You may be able to negotiate acceptable spreads to enter the trade. You will not be able to do so if you need to exit. It is usually better to stay away from these snares.
  7. Option orders executed as spreads always receive better fills than individually placed orders.
  8. Failure to consider current IV in an historic framework for the particular underlying will usually cost money.
  9. Failure to follow predicted changes in volatility prior to a known event (e.g. earnings) indicates there is some factor of which you know not. When discovered, it usually impacts your position negatively.
  10. Failure to use and understand option modeling and option modeling software puts you at a significant competitive disadvantage to other participants in the options market. The only thing more expensive than having appropriate tools is not having them.
  11. It is stunningly easy to “roll more than you can smoke”. It is usually disastrous to attempt to smoke all you rolled if you find yourself in these circumstances. This is another reason to model trades and crisply define risk.
  12. If you create multi-legged option beasts by manually entering the orders as opposed to entering from a graphical presentation, you will enter positions incorrectly and end up “upside down” and commit other similar errors more often than you thought possible. You must monitor the magnitude of extrinsic value when short options are ITM. Failure to do that and considering your trade plan in light of these developments, will result in unanticipated early assignment at the most inopportune times. Option positions can be easily adjusted to improve their structure only before they enter the ICU.
  13. Forgetting to honor time stops when holding certain varieties of option beasts can be as costly as forgetting price and/or P/L stops.
  14. Good traders know what they know; great traders also know what they don’t know. (more…)

Favorite Quotes from “The Big Short”

Here are some of my favorite passages in the book:

On bank stocks’ book value:

He concluded that there was effectively no way for an accountant assigned to audit a giant Wall Street firm to figure out whether it was making money or losing money. They were giant black boxes, whose hidden gears were in constant motion.

Regarding the value added by sell-side analysts:

You can be positive and wrong on the sell side. But if you are negative and wrong, you get fired

On Manipulation of the masses:

How do you make poor people feel wealthy when wages are stagnant? You give them cheap loans

On Recognizing when a credit driven bubble is about to burst: (more…)

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