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The Heston Recipe

  
  Education
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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…)

Coast is Clear

  
  Education
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1. Swear off the stock market forever. Look, the reality is that making money in the stock market is hard. Most of us just don’t have the emotional makeup to do it. That’s OK. If during the last 10 years you’ve found yourself making big behavior mistakes over and over, then stop. You might be  better off just committing yourself to a life of owning only certificates of deposit, given how poor your stock returns could be if you trade too much.

2. Act like you have a blind trust. Find someone you trust, give them your money, tell them to buy you an index fund and then have them update you again in five years. This could be a financial planner like me, but you could also enlist a trustworthy friend who won’t charge you anything for the privilege.

I know that there are people who have been successful, people who behaved correctly. If you are one of them, congratulations and keep doing what you’ve been doing.

But we have to recognize that the way most of us have been doing things hasn’t worked, and it probably won’t work in the future.

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