Does it really matter?

As October is drawing to its end the whole world is looking forward to seeing the biggest event that is going to happen in this early November. Yes, you got it right, the U.S. presidential election. It is important not only to the U.S. and the Americans but to most parts of the world as well because with Trump has stirred the world as well as the U.S. itself upside down in the past four years so people just wonder whether this guy is going to win another term of four years and keeps stirring the world, especially amid the pandemic.

The polling is going to end on November 3 local time so most people think it is the decisive day on the presidency. However, those who know know that November 3 is only last day of the polling by the Americans but actually they do not have the right to vote for their president. It is only the electors in the Electoral College have this right. They are the ones who are really going to decide who is going to be the president of the U.S. and their voting happen on December 14 only so it is more than one good month later than November 3. 

Customary and usually the Electors should align their vote with the popular vote, ie., the wish of the general Americans in their states to cast their own vote but it is not strictly legal bidding. That is to say, the vote from the general Americans does not necessarily reflect the result of the election even if a candidate has won a majority of ballots on November 3. The result on December 14 after the electoral college voting is after all the real one. The fact is that electors' vote could be contrary to the popular vote in their states. So folks, just forget the date of November 3 which is just a show of democracy only.

Despite the U.S. is the largest democracy country in the world but judging from its indirect election system, the so-called one person, one vote, is actually a counterfeit. The establishment of the electoral college was actually a big scam to the general Americans and it was done in purpose by the founders of the then newly formed nation. Everybody know that the U.S. was once the colony of the British Empire prior to its independence. After fighting eight years with their original sovereign nation, the colonists finally won the war to form a new born nation. Most of the founders who were responsible for drafting the constitution were lawyers. 

Contrary to most of their fellow who were farmers and laborers that were mostly illiterate, these lawyers were well educated and astute. They engineered the constitution which is in favour to these elites by designing the indirect election system via the establishment of electoral college. The system prevents the general mass, due to their numbers, from electing an inappropriate president under the simple one person, one vote, election system especially when the overall education level of the general mass was still very low thus prone to stupid and emotional decision.

The original intention of the electoral college might sound reasonable under the particular context at that time. However, this system remains unchanged even after two centuries and the general mass of Americans have already received education and most of them are sensible enough to pick their president. Yet, their right is still deprived despite of the name of leader of the democracy world. What an irony!

In fact, it is not only the problem of the crippled election system but the faulty institution to be blamed. Under the current political context in the U.S. that with the oligopoly of the Republic Party and Democratic Party so the Americans are only subjected to a choice of lesser evil when choosing their president. After all, the president of the U.S.A. is only a front stage figurehead of the political party which he represents. The point is that both of these two parties are for the interests of their respective vested interests groups only. None of them is really the guardian of the general mass of the Americans. So does the election really matter to you, Americans?

Probably the greatest discovery ever (3)

In my previous post probably greatest discovery ever-2 I lightly touched on the role of probability plays in option strike picking. I also compared the three alternatives on the access to the probability of option strike. In this post I am going to explore why probability is so important in option trading from another perspective. 

Option trading can be fun and could be profitable as long as one knows what option is all about. Option is a derivative of an underlying asset like stock or index. As explained in the previous post, some traders use option trading simply as a speculative tool especially those standalone Long traders who solely wish their trades can go into ITM to enjoy the exponential growth of the premium while the Short traders are usually less aggressive and just hope their trades can remain OTM so that they can earn some humble profit, ie., the already known premium amount received as soon as the trade is established. 

However, apart from the speculative application, option actually has a more functional purpose or usage. For some big investors with a huge portfolio or the fund managers who have an enormous holding under their management, the constant market fluctuation is a headache to trying to maintain the value of their holding in a comparative stable level. This is when hedging comes into play and option is a good hedging tool particularly the Long Put option against the anticipated market plummet. The profit from the Long Put position hopefully can off-set part of, if not all, the loss on the portfolio in case of a market crash. 

Unlike the speculators who hold their Long position solely for a speculative profit, the hedging Long Put is a kind of protection against an anticipated or unexpected market plummet. Just like any trade on earth that there must be counterparts for either the buyer or seller, whenever there is a Long then there is inevitably a Short in the option trading. That is to say, when one, due to the need on hedging, longs put say a stock option then s/he needs a short put counterpart so that the trade can be made. Naturally in the real world there are market makers so the counterparts might not be the same like those in the property transaction that a house owner matches with a house hunter. Anyway as a whole in the market, all the Longs must be equal to all the Shorts.

While there are at least two different types of long put traders, ie., speculators and hedge-seekers, but their counterpart, ie., the short put traders are rather unanimous. They all want to receive the profit, ie., premium, by shorting put. Short traders receive the profit upfront when the trade is made but at the same time they assume the risk of their position going into ITM if the underlying asset plummets prior to the expiry of the option and they will face potential huge loss if the ITM is very deep. As option trading is a zero sum game so the loss of the short traders is exactly the profit of the long traders and this is what and when a speculative long trader makes profit and a hedge-seeker can be protected. 

To the hedging Long trader's eye, the Short trader is just like his/her insurer whom will pay him/her back his/her loss on the fall of value on his/her portfolio. While from the fact that Short Put traders receive premium and assume the risk if there is a plummet and their loss could compensate the Long Put traders then they are really acting like an insurance company, an individual though. 

Everybody know that the business of the insurance industry is fundamentally a business based on probability. The probability of the event that being underwritten dictates the details of the policy especially the premium payable. With the perspective of the nature that Short traders are insurer underwriting the risk of their Long traders counterpart, this explains how important it is to look at the probability of the strikes of their position if they want to play safe. After all, Short traders are no different from running an insurance company. Shouldn't probability be treated as the most fundamental determinant when committing on any option trading, when the potential loss could be huge?

Probably the greatest discovery ever (2)

In the earlier post probably greatest discovery ever I said, as being a option trader, that probability is such a good thing especially on the strike picking because apart from reviewing all the technical indicators on the supports and resistances and the analysis on the open interest of other derivatives like the Futures and CBBC, the decision on a strike boils down to whether the strike will become ITM or OTM at the settlement day. Notwithstanding there are Straddle, Strangle, Butterfly...and many other option strategies but boiling it down to the most foundamental components there are only Long and Short while Long prefers ITM vs Short avoids ITM. Therefore the tool that helps predict whether a particular strike will go ITM is paramount to an option trade.

In that post I have slightly touched on the saying that in option trading shorting at a strike with p=0.1 of being ITM is usually safe in a normal market situation. Perhaps not every reader is familiar with option trading so I am going to explain a little bit that in the option trading world, some traders use option as a hedging of their positions in assets holding like stock while some just trade for profit without any need on the hedging of whatsoever. For the latter, profit could be from receiving the premium on their short position or the price difference after the settlement of their initial long position. Long position traders is betting on the strike(s) of their trades will go into in-the-money (ITM) so their profit can grow exponentially but Short traders just prefer the opposite because basically they are the counterparts of the Long traders despite not necessarily be of any of a particular trade concerned. Simply speaking when a Long trader makes money there must be a Short trader losing money in a particular trade because option trading is a zero sum game . Therefore Short traders never want to see the strike(s) of their position go into ITM.

I hope the above little explanation can shed some light on why I said a tool that helps to predict whether a particular strike will go into ITM is so important to all option tradings. That also explains why probability is so helpful because when the probability of a particular strike is known then it is just all about a trader's discretion on whether the risk of the trade is justified. In that earlier post I said luckily the probability of a particular strike in option trading is, unlike some other events which their probabilities are difficult to tell, rather easy to be determined, scientifically and objectively. 

For any seasoned option traders, they should be well versed in the jargon in option trading like Delta, Theta, Gamma and Vega...etc. Among these jargon, Delta is defined as the ratio of the change in the price of an underlying asset with the change in the price of a derivative or option. However on the other hand, it is also known as the probability. For example, a strike with 0.2 Delta means p=0.2 or 20% possibility being ITM. One must understand that the Delta of a particular strike does change along with the price movement of the underlying asset though so that probability is better seen as a snapshot of the moment concerned only. Therefore it is rather risky to make a trade base on the Delta reading of a strike to assume it will remain the same till the settlement day especially when there is still a long way to go. 

Considering the drawback of the Delta, some traders resort to the option pricing theory  to use the Implied Volatility (IV) to work out how likely a particular strike of an option will be exercised, ie., being ITM. In real life, IV is quoted by market makers who are usually more market intellectual to judge the riskiness of a particular strike so supposedly to be able to assign the corresponding IV. Basing on the quoted IV, traders can work out the likelihood of an option will be exercised at the expiration according to the formula of the pricing model. However, apart from other elements, the underlying asset price is also one of the variables used in the formula. Therefore using the IV on the calculation of probability literally has the same drawback as the using of Delta. Meanwhile, to the contrary to the Delta, market makers often quote a higher IV when the market is volatile but then when an higher IV is used to be the variable on the calculation in a specific market volatile moment the result tends to be fluctuant thus making it less reliable.

In light of the pitfall of the Delta and option pricing model, I prefer to refer to the historical data. For example for a spot month trading, the past record of the percentage of the monthly closing price vs opening price is used. These past percentage figures, say for the last 10 years, are ranked from smallest to biggest then it is easy to find out which percentage is within the 10% of the smallest as well as the 10% biggest. Those 10% smallest should be negative representing the most extreme adverse months while those 10% biggest are positive representing those extreme good months in the past 10 years. The thresholds right before these 10% smallest and 10% biggest biggest are what I am looking for and are used to become the risk determinants. That is to say, the strike is chosen at the same percentage of these thresholds comparing to the month opening price of any particular spot month trading. Naturally whether it is 10% smallest/biggest or whatever percent just rest on the risk appetite of the trader at their own discretion. 

The above methodology is the application of the probability based on historical data. This idea might not be most scientific but it has taken the history into account. Some argue that history is something happened in the past and it is not necessarily able to predict the future. As Mark Twain puts it that history doesn't repeat itself but it rhymes. Those good months or bad months could be as the result of different causes but the magnitude of their impact in the market were clearly marked in the history which can be used as a reference to whatever happening or going to happen in the future. For example if there will be a black swan event in this month which is not bigger in scale than the financial crisis in October of 2008 then it is quite reasonable to assume the plunge should not exceed the magnitude in that month which falls into the 10% adverse months bracket. Therefore any strike with smaller decline percentage than was that in October, 2008 should be a safe one no matter what the black swan event is.

Having said, the application of probability based on historical data doesn't come without pitfall of its own. The prerequisite of this methodology is the binomial distribution of the past data. Meanwhile even if this criteria is met, if the black swan event is so big and bigger than any past events throughout the statistical measured period, ie., 10 years in the example, then the assumption is simply not applicable. Luckily an as longer as possible period in question should be able to address the issue, largely if not completely. What still makes this methodology fails is that if there will be a mega crisis in scale which has never happened in human's history before like the outbreak of a worldwide nuclear war then the historic statistical data just fails to do their job. However, the point is, if there will be such a devastating nuclear war, then do we still exist? So do we still care about the option traded?