After-work Activities: Should you Trade, Invest or Study?

Among the perks of undergraduate living is that you are free to canoodle with spreadsheets.

This spreadsheet attempts to put in absolute dollar terms, the cost of pursuing 3 activities in one's adult life after work hours that doesn't involve liquor, women/men, social activities etc. over 1 year and excludes cost of living.

In this hypothetical case, Mr A Hardy either actively trades with a strict money management strategy, invest for the long haul (i.e. A Long-only investment strategy, but Mr A Hardy believes in careful allocation of funds across portfolios, so he insists on picking his own funds/ stocks/ bonds etc. No shorts or puts or speculative derivatives trading, however) or he can pursue his MSc in Financial Engineering. A course of study which opens doors and earns him the right to climb into a higher tax bracket. (or so he hopes!)

Here's a couple of non-surprising findings.

Trading is ok when one does it for a hobby, but it blows once you do it for a living. Take a look at line (L) of the spreadsheet. By far, investing gives you a much larger share of net wealth, and this is before Cost of Living mind you!

Also note, that these activities are over a 1-year basis. So the negative Net Wealth for Studying Option is amortised over the rest of your remaining life. Furthermore, you make up for that loss by moving into better paying jobs, or earn a higher salary.

Trading, some claim, offers an additional or alternative stream of income. This is true so long as the input less than the output. Consider how much effort,energy and time it takes to maintain one's shareholdings or trading portfolio? If you work in the office, and you work at home, is there space for your family? Is there space for your own interest?

The biggest attraction of getting into trading and investing is the vibrancy of one's after work life. People who are doing stuff with money seem very involved. Its a wee bit like footy lovers. All they seem to do is talk soccer.

It is my personal belief that people who say they trade to become richer are deluded. They trade for the thrill and for the pleasure of seeking something arcane and mystical that has opportunity for wealth. After work traders are modern alchemists.

How NOT to trade equity warrants.

Last year, I made money and lost it again trading warrants. I was up $7000 in May, and in the months following the sub-prime crisis, saw my profits erode to nothing. 

At the start of the year, I had already formed an idea of which sectors were in play. For Singapore in 2007, it was all about the IR industry, the property markets and the financial sector - specifically the banks. 

I was fixated on this sectors and never went around to look at other companies. I was sure that these companies would report good earnings because the economic indicators and numbers looked good. Logically for me the best bet would be to go long on these stocks. 

The earnings report were good. But being right does not guarantee profit. 

(Stock prices are not a function of earnings alone, they're also a function of public perception of risk. People attach risk premiums to the risk-free rate of return and discount future earnings by a larger amount. Stock prices fall, system wide, when people perceive increased risk in the economy. that's why sub-prime crisis is such a bummer.) 

On warrants:

1. As expiry nears, if the warrants weren't in-or-near-the-money already, then there's little chance for the warrants fair value price to move. Let it go if it doesn't fly.

2. Before buying a warrant, draw a timeline, figure out when the company will report earnings. Where possible model for Dividend effect and Earnings effect. As you draw nearer to that date, watch the warrants very carefully. 

3. If warrants go down by 10%, exit position ASAP. Don't average down no matter how far away the date to expiry is.

On Trading:

1. Never trade with money you can't afford to lose.

2. Take small losses early. 

3. Have a trading system. Back Test. Position size. And Keep good records.

4. Write down your Entry and Exit plan and stick to it.

5. Consistency is the key to Profits.

DIY Portfolio Analysis

Had a poke around the net and found this company, Structured Data LLC, based out of NY. They have a website riskamp.com 

They offer a free excel spreadsheet which allows you to model a portfolio. You do have to download their monte carlo excel add-in to use the spreadsheet.

The idea behind a Monte Carlo analysis is to model the results of a portfolio (can be actual or theoretical) by subjecting it to n random trials. You can then extrapolate the probability distribution functions, mean returns and figure out if you're committing too much or too little of your money into equity, bonds or money markets.

"Fuckyounomics: How Nobody in the World Knows Jack Shit Except Economists"

This is how the average professional economist thinks of you lot, for all that you pay his wages; you’re a bunch of mugs who are incapable of understanding anything and just react like children to whatever’s dangled in front of your nose. It’s another of the many scandals of the profession, it is taught in the universities, and you can see it in more or less every popular book entitled something like “Fuckyounomics: How Nobody In The World Knows Jack Shit Except Economists”.

In Harry Potter novels, magic users call non-magic users "Muggles". Magic users are powerful, trade in information and are privy to the arcane arts. 

Greg Mankiw likens the economist to the magic user of the Harry Potter world. 

The truth is that the economist uses models to understand the behaviour of people and their interactions when exchanging one good for another by ABSTRACTION. We are however pretty much interested in how people decide between alternatives subject to limitations such as time, income. Lately, we've even begun to use economic tools of analysis in figuring out how much a dollar of clean air is worth. 

We like to use the dollar value of an outcome not because (1) we believe in an Almighty Dollar, (2) are secretly in search of the Philosopher's stone, or (3) in league with Mammon. We express the "event as a dollar of something else" so that it becomes cardinal and vastly more interpretable. 

The problem with media is that a lot of the underlying assumptions are not being communicated to the public. Furthermore, a lot of the work is unseen and not easily understood without prior study. Economists should do a better job of explaining themselves so as not to alienate the people they serve or wall themselves of in our ivory towers. 

If Economists were wizards, than we should aspire to be more Gandalf than Saruman. 

Read more here: http://crookedtimber.org/2008/03/20/thank-you-mr-mankiw/

63 year old, former night watchman , now teacher at Bar Ilan University solves "Road Colouring Problem"

A mathematical puzzle that baffled the top minds in the esoteric field of symbolic dynamics for nearly four decades has been cracked — by a 63-year-old immigrant who once had to work as a security guard.

Avraham Trahtman, a mathematician who also toiled as a laborer after moving to Israel from Russia, succeeded where dozens failed, solving the elusive "Road Coloring Problem."- Link to Associated Press.

Having spent an evening on yongfook.com's pretty-boy blog, I was feeling disheartened by academic work. (Research is hard, it takes hours and it involves very little pay.)

For some reason, knowing that a Russian immigrant with a math degree has solved a problem in just 8 pages in pencil on a problem with real-world application, pleases me tremendously.

"First posed in 1970 by Benjamin Weiss and Roy Adler, the problem posits that given a finite number of roads, one should be able to draw a map, coded in various colors, that leads to a certain destination regardless of the point of origin. The 63-year-old Trakhtman jotted downin pencil in 8 pages. The problem has real-world implementation in message and traffic routing."

What’s the point of extracting implied probabilities from options on federal fund futures?

I like telling fantastical story analogies. So here’s my attempt at explaining what’s the point behind extracting implied probabilities from option prices.

The story goes like this: Let’s say you worked for an arms and munition plant - R&D side of course. And that for some strange inexplicable reason you were caught in an airstrike while driving home one day. Now the missile that’s streaking across the sky is carrying 1000 high explosive anti-personnel bomblets designed to penetrate soft-skinned vehicles (like the one you’re driving for example). From your lab tests at work, and hours spent analyzing bomb dispersal patterns, you have a pretty good guess of the effective dispersal pattern of those bomblets. Given the missile’s trajectory (you had a sensor installed in your car which tracks the movement of Air-to-Ground missiles being fired), you can guess which areas, ceteris paribus, would encounter the greatest concentration of bomblets.

By analogy, the missile’s flight trajectory is the possible direction of interest movements – i.e. either it goes up, down or remains at the same level. Your market macroeconomic indicators are your missile/ interest rate sensors. That bomb dispersal pattern that I was talking about, are my implied probability distribution functions. I want to map out which levels are interest rates most likely to climb or fall to.

In this case I’m looking to map out the regions of probabilities that the interest rate would climb to levels A, B or C.

"How to succeed in evil" podcast

Ever wondered what its like to be an Evil Efficiency Consultant? Follow the adventures of Edwin Windsor.

Link to "How to Succeed in Evil". Download free audiobook via Apple iTunes.

Laspayre's Index: What they don't tell you about the CPI

Here's a doodle from a tutorial.

Vaguely, the tutorial was about Consumer Price Index and alternative measures. The one currently in use in Australia is based on Laspayre's Index.

To calculate how well off you are after a price hike, you compare 2 ratios: Laspayres Index and Money Income. To calculate Laspayre's index, you take this year's prices and multiply that with last years mixture of goods. Divide that by the base year prices and quantity of goods. Next, you compare that ratio with the ratio of money income (simply, take this year's prices X this years goods and divide by base year prices and quantities.)

If it so happens that your Money Income ratio is less than Laspayre's Index that means you're worse off.

The reason why you multiply it with last year's mixture of goods is because people 'prefer' their old consumption patterns and therefore find it hard to change. Its all part of revealed preference theory.

Anyway, to get the analogy across, economists spend a lot of time thinking about how to compensate people with enough income to leave them just as they were last year. They aim to compensate people for the loss in welfare due to a hike in prices.

Now what they don't tell you is that one of the key assumptions is that they've assumed that people are inflexible and rigid in their consumption patterns. Therefore, the goldfish with a frown in a leaky bowl. (See Diagram Left Rectangle.)

Now what if people adapt to higher prices and substitute away from old quantities of goods that have gone up in price and chose new quantities of goods. What happens to our measures of how well off we are after a rise in prices?

The goldfish with the multi level, worm-hole fishbowl has got choices and though water levels may fall (analogy to welfare falling) he can still get by and choose other modes of consumption.

So I wonder if instead of worrying about compensation for loss of welfare with price hikes, why not give a person more choices instead?

Extracting implied probabilities from options

Link <http://www.bankofengland.co.uk/statistics/impliedpdfs/> to Bank of England's efforts at estimating probability density functions (pdfs) from the prices of option contracts traded on equity indices and interest rate futures contracts (see 'Notes on Bank of England Option Implied PDFs' for examples).

Thesis: Extracting Implied Probabilities from Options on Futures and OneNote2007

Currently working on a dissertation. Started out wanting to do a paper on regional Tobin Q, ended up with another, more interesting idea: extracting implied probabilities from options on futures on Fed Fund rates.

Its been done before in the US, but my supervisor suggested I try doing the same for Australia instead.

The idea's pretty straightforward, but reading up on the math isn't. As I move along I'll blog about the entire process more. Its pretty much work in progress.