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Rashomon


Total Posts: 165
Joined: Mar 2011
 
Posted: 2015-05-01 19:35
Forget about tradeable edge for a minute and ask if you could, using public options data, come up with a market-based forecasting model that would be useful to a central banker.

From a shallow literature search it seems that all approaches so far rely on the IV of the price at each strike.




Here’s an alternative model. Suppose ∃ two trader types: B and S. B are price insensitive but choose which strike they want to play at. S are quantity insensitive but choose the price.

B are the initiators. Each option in their portfolios is large enough that whether they exercise or not is significant to them. As such they are making calls about the future whereas S players are not.

S players hold such a broad portfolio that they don’t have to care what will happen: they can adjust prices such that, over a large number of trades, they will come out ok.

Under this model, central banks right now are using S’s forecasts + haggling rather than B’s forecasts. Yet if someone tried to buy 100,000 calls out 1 month at 20% above spot, everyone would turn their heads and say "These guys know something we don’t". Shouldn’t the CB be using similar such information if they want to know "what the market thinks"? Surely if people initiate a lot of puts right after a Fed announcement, Lacker wants some indicator to flash red—an indicator which cares whether the puts were 5% below or 50% below, and how many there were.






The naïvest first step along this line of thought would just be to take the OI at each strike / ∑ OI as the probability of the underlying hitting that strike. The concept is “Who would initiate the call to offer to pay the premium unless they think it will expire in the money?”.


After I thought of this model and started trying to work it out I realised there’s a serious flaw. Say the B trader doesn’t actually believe put X will hit, but B’s risk manager (or broker) says X needs to be on or else the size of trade Y (which is the one B really cares about) must go down. It could still be said (if it’s B’s risk manager) that "someone on team B thinks X will hit", but that’s not as good as a speculation.





This is the start of something I may throw up on SSRN. Posting here for criticism.

"My hands are small, I know, but they're not yours, they are my own. And they're, not yours, they are my own." ~ Jewel

tbretagn


Total Posts: 238
Joined: Oct 2004
 
Posted: 2015-05-02 22:40
Hi Rashomon. It sounds interesting, but as a macro player, having spent decent time around a very large macro player (as in top 10 worldwide), the listed market will only give you a very scarce and sometimes confusing information.
Having executed trades for that person in both listed and OTC for a while, I have many times had an impact by doing listed trades which were hedges of OTC ones (and vice versa), and cause a large market reaction as you noted ("OMG he must know something" - "sorry no, I just wanted to reduce my risk a little").
As such, and that is why so many regulators are trying to have OTC trades cleared, you could get a very wrong picture from just looking at the open interest, even though your approach is very sensible.

Et meme si ce n'est pas vrai, il faut croire en l'histoire ancienne

Rashomon


Total Posts: 165
Joined: Mar 2011
 
Posted: 2017-01-31 12:04
My idea was worked out earlier and better in the subsection It's the Liquidity, Stupid in Demon of Our Own Design.
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