You Don't Use Your Instagram Self to Trade

There is no substitute for doing the work yourself

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I have written most of what was going to be the first “real” post. Okay, maybe like half. I tripped over myself part way through doing some calculations and I realized that it is a good illustration of how things really work. I made an error. Or, really, more accurately, I did something that I love to do: I tried an alternate way of making the same calculation. Accountants call it reconciliation and it is near magic. The trouble was that my figures did not reconcile. And that was where the magic began because it forced me to dig deeper to figure it out.

The topic of what was going to be the post is that of synthetics. I am starting with put-call parity. It will help for me to describe the details. Please don’t worry if you don’t get all of it. This is not really about the math or the result; it is really about the process of not accepting a wrong answer and using it as a hook to guide you to a correct one. The trouble with trading is that there is no one around to tell you whether you are right or wrong. Sure, you get a pnl, but that is probabilistic. So when you find something in your own work inconsistent with your expectation, you owe it to yourself to follow that down the rabbit hole.

The details are: S=K=100 (S is the underlying price, K is for strike), r=b=5% (r is the risk free rate and b the cost of carry), T=0.25 (time to expiration in years), v=0.3. The results are that the call is 6.58 and the put 5.34. The difference is 1.24. I then wrote that the forward is 101.24 and that the yield on the conversion (sell call, buy put, buy stock) is 1.24/100/0.25 = 4.96%. The only problem is that 5 and 4.96 are not the same.

It was tempting to wave my hands and just keep driving on muttering something about a rounding error. But I knew it was not because I had calculated the number in jupyter notebook without rounding. Next, I thought the issue was because I was doing arithmetic interest rather than using e to compound. So I tried that and the answer dropped to 4.93. Eek. Then I really knew that I was wrong. I just did not know how I was wrong.

The theme of this blog is “breaking down option markets by first principles”. So I broke out the put-call parity formula:

or:

I literally broke it down in Excel where I calculated the discounted strike and got 98.76. And then, it was like “duh”. It is the discounted strike price! I’m not investing 100 and getting 101.24 (starting at the current price and getting the forward). I’m investing 98.76 and getting 100 (I will do a post about investing in conversions). So even though at that point, I knew I had figured it out, I still jammed it into jupyter notebook to get 5.00%.

This stuff matters! I can’t tell you how many times I was reconciling the accounting from my trading in a morning where I was off by a mere penny. Do you know how tempting it is to write that off and start trading for the day? A majority of the time that led to finding some insidious out trade. An out trade was something that had to get taken care of because it meant either someone owed you money (if you owed them money, they would likely find you) or you had the wrong position in the trading software. You want the money owed you and you want to be trading the position that you know. You don’t want to think you are trading a long delta position when you are really short. All really bad things that needed to be taken care of. My rule here is that 1) cleaning up a kitchen and 2) fixing accounting issues do not get easier with time.

Key lesson here is Do Your Own Research (DYOR). Even when everything that you read or get taught is 100% correct (and it almost never is), that does not mean that all of the nuance got communicated. There is a mis-used quote: “the devil is in the details”. That is not the original quote. The original is “The good God is in the details” because that is where things happen. The magic is not in the happening; the magic is in bringing to your attention that there is something that needs learning. And gaining that knowledge can often end up being a difference maker whether in finding a trade or winning a debate or getting a job offer.

I’m showing you the real deal. I could have done all of this, fixed the post in process, and then made it out like I had it all perfect. Like a staged instagram post. But that is not how trading works. In fact, it really is not how business or even art progress. They all progress by work. Figuring out the details of the model until it makes sense. Re-editing the script until it fully works. Pivoting until you find product-market-fit. I’ve been doing this stuff for a long time and I consider this process as above as one of my edges.

P.S. - drop me a line in the chat if you have questions or comments. Maybe I need an additional post to go through what is going on in the math.

Things I’m reading / listening / watching:

• The Forgotten Highlander by Alistair Urquhart. Recommendation from my son which came through the Founder’s Podcast. An amazing story of survival. Mind bending story of survival. I’m just about done.

• Just finished Michael Crichton’s Sphere. Very enjoyable.

• Options, Futures, and Other Derivatives by John C Hull. When in doubt, go to the sources

• Option Pricing Formulas by Espen Haug.