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Euan Sinclair How to Find an Edge

Euan Sinclair

How do you look for opportunities?

SSRN Papers, dont want crowded

Step 1: Know your type of edge

  1. Risk premium (like selling options) - usually there, smaller but stable. Akin to betting on an NBA game
  2. Market inefficiency - comes occasionally, harder to build a business on, but better returns, bet bigger

Step 2: Model Driven vs Systemic

  1. You have a model, compare it, and trade vs theoretical value. Smaller wins but less noisy.
  2. Systemic - you are dealing with uncertainties, you don't have a prediction for any specific trade, just the set as a whole. Much nosier, more profitable generally.

Variance Risk Premium

  • Big funds trying to harvest this in non sophisticated way
  • 20 or 30 years ago the VRP was so strong you could make money doing anything
In the future, it will still be there, but you will have to be sophisticated
  • you are basically selling insurance. Why would this go away?
  • its cyclical
  • Short vol sellers dont have a very good story, long vol guys sexier

Positional Option Trading

Why Write?
  • Organize your knowledge, that you already know.
  • The structure matters. It's something to hang your worldview on.
  • Also just fun when you write good prose, like a good golf shot
What does buyside & retail get wrong?
  • Focus too much on structure, and not enough on just finding an edge
  • Iron Condor is a dangerous trade
    • you get feedback from PnL, but iron condors you will have a lot of winners and a few losers.
    • you care about average, but you are getting mode
  • You don't lose money because of delta, gamma, vega, etc. You lose because market moved, or it didn't
  • EDGE —> Sizing —> Portfolio Construction
  • Edge most important, smoothness second, correlation to rest of portfolio 3rd
Equity Factors as a source of return in options
  • Take one of the legs of factors and use options on top
  • market makers do not think in these terms at all
  • GARCH model to forecast vol and then use that, worked 20,30 years ago. Not anymore
    • its become an academic specialty
  • only 8 papers on factor models & options
  • option traders think short term, fundamental factors take years
"If I was completely starting over, I'd be looking ad fundamental factors in order to predict volatility. And I think there is probably an enormous edge in that. And it would also apply to commodities."

Directional Trading with Options

Risk Neutral Probability: Don't take into consideration drift
  • Have to, otherwise you'd get some Arbitrage
  • can still put return into pricing model. you can sub rate for return and if you care about direction, that's the way to do it
    • you aren't in a arb free environment, others can take advantage of you
People backrest with a static vega amount, when the PnL would be dependent on vol level
  • no great solution, but constant vega is not bad
So many degrees of freedom in Options
  • Is there an optimal choice? How do you think about structuring
  • You can get it wrong, but can't optimize it
  • don't look at Expected Value, it will just lead you to teenies
  • take into account Kelly Criterion
  • Look at Probability of making money - technically shouldn't but i'm human
Options have expiration dates
  • yes but strategies dont, you can roll structures
  • Get out of a trade when edge is gone.
  • same reason i dont believe in stops - get out when you are wrong, not when you've lost money
Options as a risk management vehicle
  • emphasis on risk, not EV
  • covered call is actually a retail strategy with edge (collecting VRP, increasing decreases)
  • if you want to hedge, you should match products
  • Best time to be alive, on average, has always been now!
  • Maybe we won't have a vaccine soon...but the world will tend to get better again...