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Comment by JumpCrisscross | Hacker News Reader

> formula depends on a normal distribution and financial returns are random but not independent...worse than useless.

This is sort of like throwing out physics because Newtonian mechanics don’t account for fluid dynamics.

Yes, the original theory assumed that away. And yes, the original theory is taught in undergrad. But the work has been developed far past its original, adjusting for or incorporating away those initial assumptions, and—to a large degree—having been shown, empirically, to work.

(This is not your fault. Popular writing on the topic is terrible, elevating drama over accuracy. Against the Gods is one of the better ones, and doesn’t require much math.)

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>This is sort of like throwing out physics because Newtonian mechanics don’t account for fluid dynamics.

>having been shown, empirically, to work.

What exactly do you mean by this? That they are correct most of the time? Or that the person that uses them won't go bust?

This parallel between physical theories and assumptions about how the market works is bogus. In trading you can have strategies that are correct most of the time yet when they fail the impact of the loss can take you out.

> That they are correct most of the time?

Yup. Options market makers, the critical mass of dynamic hedgers, don’t blow up any more [1]. I left the business ten years ago, and was probably among the last well-paid people to do it. There isn’t much risk anymore which means there isn’t room for ingenuity—it’s execution, mechanical.

Between market circuit breakers limiting instantaneous price moves; the tremendous amount of liquidity in option-covered symbols; tail-risk estimating options models; and fully electronic options, equities and money markets, there simply isn’t empirical evidence for hidden risks in the model. Cash equities execution was once super complicated. It’s now commoditised. Same for options.

It sells books to claim otherwise. But you largely need to re-tell stories from the 90s, where LTCM bet on short-term Russian debt, or recount crisis-era structured products on illiquid mortgages to fill the pages.

[1] American OCC-cleared options market makers who aren’t making directional bets but manufacturing options and hedging their books

All of the inputs of the BS model are forecasts. All of them can be wrong, and they have been wrong countless times. It’s like saying that your linear extrapolation for the stock market mostly works, except for the times it doesn’t.

> the inputs of the BS model are forecasts

In the same way a rocket flight model is forecasting the arrangement of air molecules it’s about to run into. They’re instantaneous forecasts that are dynamically updated. No long-term forecasting involved.

At the end of the day, options market makers haven’t blown up since the early noughties. (LTCM got sunk by non-options bets.) They are low-margin, low-risk businesses. It’s fun to talk about them like they’re black boxes. And traders trying to defend their compensation will keep pitching them that way to senior management. But options pricing is a boring, largely solved—if still interesting—problem.

If options pricing is largely solved, do you think exchanges could provide an API where instead of specifying the price and quantity for hundreds or thousands of options on a stock, market makers could send a much smaller message containing their latest risk and model parameters, and have the exchange run a standard model internally to generate the quotes?

Since the model to convert parameters to prices and quantities would be known in advance to all traders, the next step could be providing a feed of current parameters which traders could use to build their own view of the public book. They'd still need plenty of quotes published piecemeal as now (as not all quotes would be model-generated) but the messaging could be much more efficient, and that could lead to more options trading.

> market makers could send a much smaller message containing their latest risk and model parameters, and have the exchange run a standard model internally to generate the quotes?

No market works like this. The smaller-still message of a price is sent and disseminated. When you buy a flight, you want the price of the ticket—not the airline’s fuel and tariff costs.

None of the inputs to the BS model are forecasts, except the volatility. What the BS model allows, then, is trading this volatility. (Just as other financial products require other inputs, and thus make them, in a sense, tradable: Cross currency swaps make the cross currency basis tradable, credit default swaps make credit risk tradable, trading index vol versus single stock vol makes correlation tradable, etc.)

The only thing it offers, is a common denominator for trading. The value predicted by the model itself is completely arbitrary. You have no clue today about tomorrows volatility or the the interest of a “risk free” instrument aka the central banker can show up tomorrow announcing -10% interest rates.

Btw when interest rates went negative for the first time, many trading shops were caught pants down, because of course their models did not have a provision for negative interest rates.

This comment is really interesting.

> There isn’t much risk anymore which means there isn’t room for ingenuity—it’s execution, mechanical

What do you mean by ingenuity here? Like coming up with your own model that was better than other people's models, or new strategies, etc?

Also, what the heck is an "aerospace investment banker"? Someone in IB who only works on aerospace stuff?

> What do you mean by ingenuity here?

Creativity. What you said. No more 10x improvement opportunities. Just marginal adjustments. Maintenance. Running the same model a bit more efficiently, carving off minuscule edge cases here and there.

> what the heck is an "aerospace investment banker"

A made-up moniker. I raised money—and did deals, e.g. IP licensing, M&A, PPP, et cetera—for rocket, satellite, drone and adjacent start-ups before that was a thing. I had enough technical knowledge to know we were and are on a precipice. Computer-aided design, singularly, as well as new fluid dynamics numerical methods being unsung and recent game changers; falling launch costs our transcontinental railroad. But not enough to do the work myself. So I sold and structured, things I am good at, while reading Banks and Nivens and K.S. Robinson on the weekends.

Really rewarding work. Didn’t pay that much, unfortunately, though the resulting equity changed my life.

Interesting job!

No creativity makes it sound like the market has been figured out. I know that isn't true, so does that mean that the risk/reward of strategies has flattened off (I.e. same risk for less reward) because there are less opportunities to exploit?

Thank you! It was.

> No creativity makes it sound like the market has been figured out

That was my bet. It has, so far, been a good one.

> does that mean that the risk/reward of strategies has flattened off (I.e. same risk for less reward) because there are less opportunities to exploit?

Your instinct was on point. You don’t need someone with a feel for volatility to make money (or not lose it) in options market making anymore. The work consists of, and will for some time, re-implementing existing ideas. There are still mis-pricings. But they aren’t inherent to the pricing model. The commodity component can be isolated and run with an eye towards costs and economies of scale.

(This has been a fun conversation, by the way. Thank you.)

Thanks for your perspective and no worries! It's always interesting to hear the opinions of people with domain expertise.

Options market makers, the critical mass of dynamic hedgers, don’t blow up any more

I wonder if that's true in insanely volatile stocks like GME? People were buying way OTM calls on that stock. Then the stock would move 50% in one day. A market maker would have to be very good at dynamic hedging to keep up with that.

Of course options market makers have one incredible thing going for them. While they have market risk for every individual option they write, their net exposure can potentially be very small. That only works for a market maker, not for someone making a directional bet because YOLO.

Edit: The few times I tried to study what was going on with GME options, I saw a lot of "no bid" on many OTM strikes. So it looks like the market makers were simply stepping away. Which totally changes the market dynamics. If there's no liquidity in an option, a punter's only choice is to hold to expiration? That's financially very risky and also counter to everything we've come to believe about an "efficient" market.

> lot of "no bid" on many OTM strikes. So it looks like the market makers were simply stepping away

Bingo. Self help [1] and circuit breakers [2] negate the unsolvable edge case: large, instantaneous price movements.

[1] https://www.reuters.com/article/usa-options-cboe-idUSL2N1H40...

[2] https://www.npr.org/2020/03/09/813682567/how-stock-market-ci...

All that promise that innovation like HFT among other things was fine because of the value liquidity they can provide and now they can just choose to not play if they don't want to.

Near the money GME options are super liquid with tight spreads, exactly as promised. If you're holding GME, but you're worried about an earning surprise, you can put on a collar for like zero cost, which is pretty crazy considering the insane volatility. Exactly what the people who said they wanted the markets to support meaningful transactions instead of speculation asked for. Nobody ever promised you'd get easy access to 1000:1 yolo lottery tickets.

Having two sets of assumptions for buy and sell side is pretty indicative of the quality of the model.

> two set of assumptions for buy and sell side is pretty indicative of the quality of the model

What does this refer to? And, no. Disagreement on inputs doesn’t convey much about a model—it’s a negotiation. Any model will have procurer and vendor using different inputs when negotiating purchase and sale. That Boeing and steel mill don’t agree on tensile strength assumptions doesn’t mean aircraft designers are winging it.

Buy-side firms don’t use BS with the same assumptions as market makers. If you’re a fund manager, you are interested in objective estimates of the value. If you’re a market maker you want to show that you can perfectly replicate and thusly hedge your derivatives. Never mind that you have to recalibrate your model every 20 minutes.

For a model that is supposed to measure the objective value of an asset, that’s clear failure. BS is at this point just a vague market consensus which stinks more and more, the farther you stray away from vanilla European options.

> Never mind that you have to recalibrate your model every 20 minutes

Let me know when we make a plane or rocket that doesn’t need to recalibrate it’s flight model every millisecond.

As I said, market neutral market makers will use different assumptions from directional buy side shops. To say nothing of their vastly different funding costs and structures. Using input heterogeneity or calibration frequency as an estimator of model quality is...odd.

We never recalibrate the g constant in our calculations nor we wait a person to announce what the g for this quarter will be.

> We never recalibrate the g constant in our calculations nor we wait a person to announce what the g for this quarter will be

Sure. But we do update all manner of atmospheric, gravitometric and similar factors in our flight and orbital models. Once again, calibration frequency is a poor predictor of model quality. There are useless models in every domain involving immutable constants. And there are very good numerical methods that have no constants per se.

Planes don't crash all at once every few years and resume flying only when the airports renegotiated the basic laws of physics. What you are referring to as "re-calibration" in planes and rockets is actually stochastic control and is a completely different topic to calibrating a stochastic model. But hey, I guess you like your metaphors like your risk models: incorrect.

Wilmott covered model robustness and calibration frequency. Any time you have to adjust an unobserved term in your SDE (like market price of risk, for example) you are changing the model. So if your model has to be changed every x minutes else it gives wrong results, you're not "adjusting your inputs", you are just using T/x shitty models.

Some sense.

Comparing financial markets to physics is pretty much what made it all explode last two times.

It is getting ready to explode again.

The asset market has been sedately rising for a decade. Which makes models like really good.

\sarcasm{ON} This time is different \sarcasm{OFF}

No it is not.

One should clarify that basically nobody tries to "predict" anything with Black Scholes, just as basically nobody "predicts" share prices by doing a discounted cash flow analysis. Yet, they each provide the conceptual framework for trading (of options and stocks, respectively) in such a way that those that have better predictive power make money, on average, at the expense of those traders that don't. With that, they make the market efficient for traders that trade for other reasons (hedging, investing, gambling, etc.).

It's a market convention, with as much predictive power as knowing options used to be quoted in vol points.

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