The Market Faces a Terrifying Challenge – And Here’s How We Avoid It
In my past life in the world of Big Money investing, I spent eight years as head of “equity derivatives” for North America for Cantor Fitzgerald.
Cantor Fitzgerald is one of Wall Street’s blue-chip financial firms, and I mention that only to let you know that it meant tons of money came across my desk – or my computer screens, to be more precise.
And handling all that cash, I learned invaluable lessons.
Derivatives are a whole other investing market out there. And not some secondary market that offers alternatives to stocks or bonds.
Derivatives happen to be the biggest in the world. By a longshot.
Even most of the “experts” don’t really understand it. It’s so complex that most journalists just avoid it. Which means you hardly ever hear about it.
A lot of investors barely know this market exists. Even more don’t know that there’s a major flaw underpinning almost every trade made in this market that’s so massive you need 15 zeroes to articulate its value.
So, what the heck are derivatives anyway?
Derivatives are investments that “derive” their value from some other asset. They include futures contracts, swaps, forwards, and the most well-known – options.
In my case, as head of equity derivatives, I was deep in the world of stock options. Options are tradeable contracts that give the owner the right (but not the obligation) to buy or sell the underlying stock at an agreed upon price.
Options can be complicated, confusing, and risky. If you don’t know what you’re doing, you can lose a ton of money. A lot of investors want nothing to do with them, and I understand that.
But if used properly, they can be smart, safe, and slick strategies to boost profits, generate income, and/or reduce risk.
I get question about options from you – questions I’ll talk more about in future Power Trends.
But I want to set the scene today with two critical pieces of information that should give any investor pause:
- The global derivatives market is mind-blowingly massive, and…
- The globally accepted pricing model used to trade derivatives has a serious flaw that we need to think about in owning stocks as well.
That’s A Lot of Zeroes
When I headed up a trading desk and matched Big Money buyers and sellers, I routinely filled orders worth many millions of dollars. It was pretty cool when I started, then quickly became part of my daily regimen, and I got use to handling massive sums of money.
And that brings us back to the global derivatives market – and a dollar value that, even with all my years of experience, still stops me in my tracks. According to some estimates, we’re talking more than $1 quadrillion big.
I’ll save you the trouble of looking that up. It’s a “1” followed by 15 zeros, as in…
$1,000,000,000,000,000.
That’s 25 times the U.S. stock market – which was valued at $40 trillion (or 40 followed by 12 zeros) at the end of last year.
It’s even bigger than the entire $105 trillion global economy
Here’s the scary part: That much money is changing hands based on a flawed pricing model.
Here’s What’s Missing
Options are leveraged bets on the future trading price of the underlying asset (stocks, bonds, currency, interest rates, indices, ETFs, and more). And when you’re talking about the future of anything – stock prices, hockey standings, the weather – the further out you go, the more uncertain that picture becomes.
And that uncertainty made options really tough to price.
Or at least it did until the Black-Scholes Equation came along. This stroke of genius (give or take) provided an elegant way to price options and explain risk.
Black-Scholes came to life about 30 years ago when three math geniuses got together and crafted the formula that earned them the 1997 Nobel Prize. Myron Scholes at MIT met Fischer Black of Goldman Sachs, and Robert Merton also of MIT eventually joined the party. Together, they authored the famous Black-Scholes Equation.
Three decades later, that equation remains the foundation for valuing much of that quadrillion-dollar derivatives market.
It’s brilliant. Don’t get me wrong. It deserved the Nobel prize.
But the equation itself is fundamentally wrong.
Here’s why: The model factors in a stock’s (or any asset’s) price swings in a way that is often not even close to the way it trades in real life.
Black Scholes factors in realized volatility based on closing price alone. If stock ABC closed yesterday at $100 and closes today at that same $100, the realized volatility is zero. The price didn’t move.
Or, at least, it didn’t move from close to close. But there was an entire trading day in between. What if that stock dropped to $85 early, rallied back to $115, and then slid to end the day at $100? That would be a 35% move from bottom to top in one day – and 35% is a heckuva a lot different than zero.
Avoiding That Fatal Flaw… and Making Money
That intraday volatility is important to understanding how a stock trades, or what I call the technicals in my Quantum Edge system. I think it’s crazy to ignore that.
It’s like trying to determine your body-mass index (BMI) – but using somebody else’s physique to make the calculation.
I prefer average true range (which you might see abbreviated as ATR) in my calculations and algorithms. Specifically, I triangulate a stock’s daily high, daily low, previous close to high, and previous close to low.
If you don’t understand all of that or simply aren’t interested, I get it. That’s what my readers pay me to do. The point is that it gives me a wider and more accurate range of volatility, which in turn helps me better measure the risk of buying or holding on to a stock.
The derivatives market highlights the dangers of relying on imperfect math. I have a pretty narrow view of the best way to use options to avoid getting burned by this Black Scholes flaw, which I’ll share with you in a future Power Trends.
I prefer straightforward math that helps me analyze the right data the right way, which stacks the odds in my favor. My Quantum Edge computers analyze more than one million data points on more than 6,000 stocks every single morning.
The algorithms may be sophisticated, but the concept is easy to understand: Invest in the best stocks in the market, which are those with superior fundamentals, strong trading technicals, and Big Money flowing in.
We buy the best of those, and we use average true range among other calculations to determine Risk Points. These are thresholds where the risk is beginning to outweigh the reward, and they are often a time to move on to new opportunities.
This has been a tremendous advantage that has resulted in a 70% success rate through years of use and back testing. And I’m happy to say, there’s no flaw in that calculation.
Click here if you’d like to learn more about Quantum Edge investing.
alk soon,
Editor,
Jason Bodner’s Power Trends