Kind of Timely; Atlas Shrugged; Fiction Meets Reality.

Jeff  Carter
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Posted: Jul 20, 2012 12:01 AM

From the book Atlas Shrugged. It’s required reading in my house.

“He didn’t invent iron ore and blast furnaces, did he?”

“Who?”

“Rearden. He didn’t invent smelting and chemistry and air compression. He couldn’t have invented his Metal but for thousands and thousands of other people. His Metal! Why does he think it’s his? Why does he think it’s his invention? Everybody uses the work of everybody else. Nobody ever invents anything.”

She said, puzzled, “But the iron ore and all those other things were there all the time. Why didn’t anybody else make that Metal, but Mr. Rearden did?”

Part One, Chapter Nine.

Growth In The Financial Markets Starring the Quants

Was talking to someone yesterday about growth in financial markets. How do we get more growth? The Captain Obvious answer is innovation. But what will innovation look like? Where is that growth going to come from?

Venture capitalists are placing bets on various industries. Nanotechnology, bioengineering, and other high tech stuff like that. This kind of investing though is simply blocking and tackling analysis, then hoping that you are right and the team you picked executes like heck so you can make some money.

The core of big data is variance.

Variance is the spread of the standard distribution. Larger variance means a larger spread. Or, in layman’s terms the larger the variance, the more uncertain we are of an outcome.

If big data is processed and analyzed correctly, that changes. Variance should shrink, and our decision making should be a lot less random. But what does that look like in actual practice?

In financial markets, it should mean that the options market will grow exponentially. Because of the preciseness of data analysis, options are a far less risky way to test a market hypothesis than an outright futures ETF or stock trade.

The advent of quants in the financial business is a relatively new phenomena. It’s only been the past fifteen years that quants have had a big effect on the business. So far, quants have concentrated primarily on the big markets; equities, futures, ETF’s, equity options. It’s where the lion’s share of money is.

But, as more quants enter the business and get more sophisticated at manipulating data, the options markets in the equities ($CBOE) and futures markets will boom. Someday, it wouldn’t surprise me to see the options trading more than the equities.

In equities or straight futures, there are two basic ways to make money. Buy or Sell. In options, the combinations are virtually unlimited. Having so many ways to make money gives you a lot of ways to hurt yourself too! But, there is a lot of untapped potential in the options market.

Secondly, in some cases options positions can insulate traders from the perniciousness of predatory HFT algos. As the futures market, or stock market roils up and down with the noise created by HFT, the options won’t move as much. The other advantage is that once I pay for a call or put, I am done putting money in the position.

On the futures side, trading options is not automated. It’s simply more efficient to trade them in a pit at this point than on a screen. The problem lies in the bandwidth. When pipes get big enough to handle all the data, quote streams, and trades, then options will move to the screen.

If you are a younger trader, start learning options. It’s a lot of math, calculus combined with statistical analysis, but if you want to be in the business for the long haul, it’s worth it to learn. One book that explains it all is Options as A Strategic Investment. Once you get the math down, then you still have to be a real good trader.

Stocktwits has some options bloggers you can read. Investing With Options and Dragonfly Capital will write about equity options.

Quant or not, there is no replacement for the cunning skill of a good trader. That’s been true since the dawn of markets back in prehistoric times.