mandelbrotian randomness in finance, examples of practical uses?

[RedManPlus]

[ QUOTE ]
I was trying to make more of a philosophical point, but failed, I think. You brought up Taleb, which allows me to restate my point, maybe more clearly.

The problem I have with Taleb's writing, albeit based only on Fooled by Randomness - I haven't read Black Swan, is that he seems to pound the table to point out that:
1. People are overconfident about their ability to understand statistics and don't have the ability to estimate or appreciate the true distribution/probability of events. Alternatively, people fail to appreciate the degree to which unexplainable "randomness" exists in data.

2. People underestimate the likelihood of rare events.



[/ QUOTE ]

I've managed a hedge fund for 15 years...
Using classic quant analysis.

Non-professionals are dazzled by Taleb...
And view him as an uber-Guru.

Actually...
Taleb is a promoter...
And simply repackaged well-known phenomenon...
Stuff that the Top 10,000 traders have known for decades.

For example...
The world's best selling option trading book by McMillan...
In the 1986 edition...
Devotes a lot of space to "fat tail" distributions...
Because market prices are not Normally Distributed at the tails...
And "rare events" happen more often than the Normal Distribution would imply.

So Taleb comes up with the cool "Black Swan" metaphor...
And laughs all the way to the bank.

There is NO evidence that Taleb has ever made a dime for anyone...
There is zero info on this on the web...
So he must get all clients to sign iron-clad non-disclosure agreements...
And then he must threaten/sue ex-clients to enforce these agreements.
Must be a real stand-up guy.

In fact...
His silly core strategy on buying waaaaay out of the money options...
Would have been a disaster the last 3-4 years...
(Because we have had the lowest market volatility EVER).
Even if on could actually find Option Pros willing to sell you such options...
Which is highly doubtful.

Being a promoter is all about telling a "good story"...
And that is Taleb's primary talent.

He is really saying that Top Option Pros are idiots...
Which is like selling a book that reveals that Top Poker Pros are idiots.
How credible would that be at 2+2?

[DcifrThs]

[ QUOTE ]
[ QUOTE ]
I was trying to make more of a philosophical point, but failed, I think. You brought up Taleb, which allows me to restate my point, maybe more clearly.

The problem I have with Taleb's writing, albeit based only on Fooled by Randomness - I haven't read Black Swan, is that he seems to pound the table to point out that:
1. People are overconfident about their ability to understand statistics and don't have the ability to estimate or appreciate the true distribution/probability of events. Alternatively, people fail to appreciate the degree to which unexplainable "randomness" exists in data.

2. People underestimate the likelihood of rare events.



[/ QUOTE ]

I've managed a hedge fund for 15 years...
Using classic quant analysis.

Non-professionals are dazzled by Taleb...
And view him as an uber-Guru.

Actually...
Taleb is a promoter...
And simply repackaged well-known phenomenon...
Stuff that the Top 10,000 traders have known for decades.

For example...
The world's best selling option trading book by McMillan...
In the 1986 edition...
Devotes a lot of space to "fat tail" distributions...
Because market prices are not Normally Distributed at the tails...
And "rare events" happen more often than the Normal Distribution would imply.

So Taleb comes up with the cool "Black Swan" metaphor...
And laughs all the way to the bank.

There is NO evidence that Taleb has ever made a dime for anyone...
There is zero info on this on the web...
So he must get all clients to sign iron-clad non-disclosure agreements...
And then he must threaten/sue ex-clients to enforce these agreements.
Must be a real stand-up guy.

In fact...
His silly core strategy on buying waaaaay out of the money options...
Would have been a disaster the last 3-4 years...
(Because we have had the lowest market volatility EVER).
Even if on could actually find Option Pros willing to sell you such options...
Which is highly doubtful.

Being a promoter is all about telling a "good story"...
And that is Taleb's primary talent.

He is really saying that Top Option Pros are idiots...
Which is like selling a book that reveals that Top Poker Pros are idiots.
How credible would that be at 2+2?

[/ QUOTE ]

he introduced me to Benoit Mandelbrot again (first time was a mention in a chaos book i was reading). for that he gets a gold star!

i don't really care if he made money for anybody or if he makes it himself.

power law distributions and replicating realistic price change histories is what i'm enjoying researching now thanks to him and his re-intro into mandelbrot and fractal and multi-fractal distributions.

did McMillan go into power law distributions? or did he try to alter a normal one?

if the former then he deserves more credit b/c the mathematics behind option pricing with power laws is formidable (and i dont' think was complete ... or even istn' complete now)

by the way, what strategy do you use in your fund?

i don't mean to be so vague, but if i were describe a number of strategies they could be "global macro, quantitative modeling driven via fundamental values + flows + intermarket action"

or just "global macro" or "equity M&A" or "equity convertible arb" etc. etc.

i just want to get a sense for how you ran things.

thanks,
Barron

[RedManPlus]

[ QUOTE ]
[ QUOTE ]
[ QUOTE ]
I was trying to make more of a philosophical point, but failed, I think. You brought up Taleb, which allows me to restate my point, maybe more clearly.

The problem I have with Taleb's writing, albeit based only on Fooled by Randomness - I haven't read Black Swan, is that he seems to pound the table to point out that:
1. People are overconfident about their ability to understand statistics and don't have the ability to estimate or appreciate the true distribution/probability of events. Alternatively, people fail to appreciate the degree to which unexplainable "randomness" exists in data.

2. People underestimate the likelihood of rare events.



[/ QUOTE ]

I've managed a hedge fund for 15 years...
Using classic quant analysis.

Non-professionals are dazzled by Taleb...
And view him as an uber-Guru.

Actually...
Taleb is a promoter...
And simply repackaged well-known phenomenon...
Stuff that the Top 10,000 traders have known for decades.

For example...
The world's best selling option trading book by McMillan...
In the 1986 edition...
Devotes a lot of space to "fat tail" distributions...
Because market prices are not Normally Distributed at the tails...
And "rare events" happen more often than the Normal Distribution would imply.

So Taleb comes up with the cool "Black Swan" metaphor...
And laughs all the way to the bank.

There is NO evidence that Taleb has ever made a dime for anyone...
There is zero info on this on the web...
So he must get all clients to sign iron-clad non-disclosure agreements...
And then he must threaten/sue ex-clients to enforce these agreements.
Must be a real stand-up guy.

In fact...
His silly core strategy on buying waaaaay out of the money options...
Would have been a disaster the last 3-4 years...
(Because we have had the lowest market volatility EVER).
Even if on could actually find Option Pros willing to sell you such options...
Which is highly doubtful.

Being a promoter is all about telling a "good story"...
And that is Taleb's primary talent.

He is really saying that Top Option Pros are idiots...
Which is like selling a book that reveals that Top Poker Pros are idiots.
How credible would that be at 2+2?

[/ QUOTE ]

he introduced me to Benoit Mandelbrot again (first time was a mention in a chaos book i was reading). for that he gets a gold star!

i don't really care if he made money for anybody or if he makes it himself.

power law distributions and replicating realistic price change histories is what i'm enjoying researching now thanks to him and his re-intro into mandelbrot and fractal and multi-fractal distributions.

did McMillan go into power law distributions? or did he try to alter a normal one?

if the former then he deserves more credit b/c the mathematics behind option pricing with power laws is formidable (and i dont' think was complete ... or even istn' complete now)

by the way, what strategy do you use in your fund?

i don't mean to be so vague, but if i were describe a number of strategies they could be "global macro, quantitative modeling driven via fundamental values + flows + intermarket action"

or just "global macro" or "equity M&A" or "equity convertible arb" etc. etc.

i just want to get a sense for how you ran things.

thanks,
Barron

[/ QUOTE ]

I think "Fooled By Randomness" is a great book...
And the FIRST book I would recommend to a wanna trader.

The problem for me...
Is that after 500,000 trades...
I learned nothing new from Taleb.

But for a newbie...
The concepts presented by Taleb are largely correct...
And MUST become SECOND NATURE...
The same way that advanced poker concepts...
Such as range betting, ICM applications, etc, etc...
MUST become SECOND NATURE... or you are playing dead.

The other point I'd like to make...
And something that 98% of wannabe traders miss completely...
Is the basic poker concept of PICKING THE EASIEST GAME OR TABLE.

Most new traders chose liquid options...
Or liquid futures contracts or liquid index funds or liquid commodities...
Which is very roughly like a Party $11 player...
Walking into the Bellagio and sitting into the toughest game...
You are playing against the best in the world.

I do the opposite...
I trade securities that you have never heard of...
Which are either very complex or quite illiquid...
But that's pretty much the only place you will find pricing inefficiencies...
In today's computer driven markets.

The closest you came is "conv equity arb"...
Which I did exclusively for 2 years 1999-2001...
While today I track about 400 stocks...
And will hedge/scalp almost anything highly correlated to the US bond market.

And I don't believe that one can defeat an efficient market...
Just because one employs advanced mathematics.
There is no way to exploit an efficient market.

[LA_Price]

I believe you have misunderstood what was written in Fooled by Randomness and the Black Swan.

Taleb is not saying that Top Option pros are idiots, merely that they don't quite understand the reasons why they have been successful.

He is also saying that we underestimate small probabilities when they have not happened. We actually overestimate the liklihood of them happening again once they have occured(not to say that they won't happen again, just that we never seem to get the probability quite right).

His argument is that humans are very poor at predicting.

Whether he makes money or not should be largely irrelevant to his ideas, which should be judged on their merits. He himself admits that he sometimes acts contrary to his ideas. For example when he has the cab driver drop him off at 1 block off of his usual spot in Fooled by Randomness because he had a good day the day before and was dropped there by accident.

Misbehavior of Markets is a very good book.
The important implication of Mandelbrot's book is that there is one thing that is somewhat predictable and that is volatility. It is not predictable whether the prices will go up or down, but that huge swings tend to cluster. The direction is a random walk, but the magnitude is not. Likewise normal swings also tend would cluster. So NNT would probably understand these ideas and would have bet on the fact that once a big crash or gain happens, people will overestimate the likelihood of either happening again.

I have a theory as to why all of these things are true and I believe in large part that it has to do with prospect theory. The fact that humans make different decisions when they view themselves under loss and gain. Markets are rational, that is until people start experiencing big losses and gains, and then normality, as well as rationality should be thrown out the window. Hence the fatter tails. I'm not quite sure, and am still trying to wrap my head around the ideas. If trading is done by computers with set programs the trades should be largely independent, but once human emotion steps into the equation, decisions become dependent. One need only read Rogue Trader, by Nick Leeson, to see part of this effect. I believe this is something that can be strategically exploited.

I am interested in discussing these ideas with any who are interested.

[DcifrThs]

i strongly agree with you,

and i strongly disagree with you.

Agree: hedge funds and other large money managers are often limited in their scope and miss, sometimes, the largest inefficiencies and easiest money to be made either due to imposed restrictions (leeway) or having too much money to invest in small stocks (b/c at that point they'd move the whole market to take even a small position relative to their whole portfolio).

dealing with complex, not often traded or talked about issues (in stocks) or derivatives in markets is certainly analagous to sitting in a nice soft 20/40 game after playing a tough ass 1/2 game w/ some strong players.

but, i also strongly disagree with you.

Disagree: i appreciate your posts and am glad to have somebody w/ that experience contributing...but i'm shocked that you mistake liquidity for efficiency so readily.

specifically, you state:

[ QUOTE ]
Most new traders chose liquid options...
Or liquid futures contracts or liquid index funds or liquid commodities...
Which is very roughly like a Party $11 player...
Walking into the Bellagio and sitting into the toughest game...
You are playing against the best in the world.

[/ QUOTE ]

now this may be a simple overlooking of the obvious, but just because a market is liquid, isn't sufficient for it to be efficient. take currency markets. or the UK IL bond market.

i was asked about this in some other thread. the question was, "i hear currency markets are the most liquid & thus most efficient and nobody can beat them, is that true?"

well, it most certainly is not. when you have a non-profit seeking entity doing nothing but pouring a TRILLION!!!! dollars down a sinkhole, you have what i would readily call a f*cking insanely inefficient market (where imo efficiency is correctly taking into acct all info and where all entities in the mkt are profit seeking etc. etc.).

so you can have inefficient supremely liquid markets.

the UK IL bond market's real yields are artificially low (and thus BEI artificially high) because it is mandated by the govt that all pension fudns must match liabilities & assets to some degree or other (i forget the actual reegulations). that said, the UK IL bond market is one of the biggest available to trade (though has recently been overtaken).

so overall, i agree with your assessment of maximum expectation per unit risk being available in illiquid & inefficient markets.

but i want to strongly separate the conditions for "liquidity" and "efficiency"

thanks again for your contributions,
Barron

[RedManPlus]

[ QUOTE ]
I believe you have misunderstood what was written in Fooled by Randomness and the Black Swan.

Taleb is not saying that Top Option pros are idiots, merely that they don't quite understand the reasons why they have been successful.


[/ QUOTE ]

Thank you for your response...

But actually...
The point I was trying to make...
Is that everything Taleb writes about is ** common knowledge ** to Option Pros...
And that Taleb is in the business of building a Personality Cult around himself...
Much like Robert Prechter and his ridiculous Elliot Wave theorems in the 80s.

Guys...
You have to view the Top 1000 option traders in the world...
As analogous to the Top 1000 poker pros in the world...
Except the Option Pros have 10-100 times the capital...
Plus 100 times the employee and computer infrastructure.

I used to be an Option Trader in the early 90s at the Toronto Stock Exchange...
And, like Poker Pros, Option pros are "Strategic and Risk Analysis Savants".

SAVANTS.

Genius level guys like this do not come from MBA mills...
Because world class level Zero Sum Game play...
Cannot be taught...

Stu Ungar did not grind out an MBA with a bunch of uber-conformists...
It never even ocurred to him.

People are born with these skills and become obsessed with the Zero Sum Games...
And then gravitate to Poker Tables or Option Pits from all walks of life.

http://www.fooledbyrandomness.com/fortune.pdf

This paper manufactured by an academic...
Is ludicrous...
And would be skimmed and tossed by an Option Pro.

For example...
The 2nd paragraph is a joke.

Lines like "the professors who live..."
Are comical...
Because professors are not market professionals.

In paragraph 4...
This CLOWN actually use German hyperinflation of the 1920s...
To try and scare people that invest in 21st century US markets.

This article is meant only to get publicity...
And keep pumping up the silly Nassim Taleb Cult.

And just to get back to why Taleb implies Option pros are idiots:

His "strategy" of buying options on events 3 or 4 standard deviations from the mean...
Is unworkable in real life...
Because if a Risk Savant was dumb enough to sell you such options...
And risk bankrupcy...
That Savant would probably charge you 10 to 100 times Fair Value.

Not even to mention that Taleb wants to bet on death and disaster and human tragedy.
Ol' Nassim was probably the happiest guy in the world the day after 9/11.
In my book... that is a cold, ruthless sociopath.

[RedManPlus]

[ QUOTE ]

hedge funds and other large money managers...


[/ QUOTE ]

Probably 90% of "hedge funds" are designed to be "skimming operations"...
That is... the principals know from the outset ...
That they have no chance of outperforming the market...
Except by pure luck...
But they cannot lose financially...
Because of the fee structures and the operation of multiple funds.
Losers are shut down... and the winners keep just on "skimming".

[ QUOTE ]

i'm shocked that you mistake liquidity for efficiency so readily.


[/ QUOTE ]

There is a very high degree of correlation...
Between liquidity and market efficiency.


[ QUOTE ]

i was asked about this in some other thread. the question was, "i hear currency markets are the most liquid & thus most efficient and nobody can beat them, is that true?"

well, it most certainly is not.


[/ QUOTE ]

This has to be viewed differently.

Money is not "pulled from the ether".
When you make money in liquid markets...
You are TAKING IT AWAY from a Professional Traders.
As with all Zero Sum Games...
There will be about 5% winners and 95% losers.

[ QUOTE ]

the UK IL bond market's real yields are artificially low (and thus BEI artificially high) because it is mandated by the govt that all pension fudns must match liabilities & assets to some degree or other (i forget the actual reegulations). that said, the UK IL bond market is one of the biggest available to trade (though has recently been overtaken).


[/ QUOTE ]

Focusing on one bad player in a game full of strong players...
Is some sort of common logical fallacy...
But I forget the specific term.

Barron,

As if beating efficient markets against strong opponents was not hard enough...
I'm not sure that you realize the DEGREE...
Of corruption and cheating and insider trading, etc...
In the US financial markets.

It's rampant... click on this:

http://www.google.com/search?hl=en&q...=Google+Search

I get cheated every day...
But it's just the cost of doing business.

Regards,

rm+

[LA_Price]

RedManPlus,

I appreciate your responses but I have a few questions about what you wrote.
Firstly, if the stuff Taleb writes about is such common knowledge why did LCTM go broke?

[ QUOTE ]
This paper manufactured by an academic...
Is ludicrous...
And would be skimmed and tossed by an Option Pro.

For example...
The 2nd paragraph is a joke.

Lines like "the professors who live..."
Are comical...
Because professors are not market professionals.


[/ QUOTE ]

The second paragraph doesn't seem so stupid in light of LCTM going busto. Also professors are not market professionals, but they provided the mathematics that was used to calculate risk, like Sharpe and Black. Also, weren't they mathematicians who became market professionals for LCTM?. So he seems to be attacking the source of the risk ideas throughout the article(sharpe and black).

[ QUOTE ]
In paragraph 4...
This CLOWN actually use German hyperinflation of the 1920s...
To try and scare people that invest in 21st century US markets.

[/ QUOTE ]

If you read (mis)Behavior of Market by Mandelbrot, he argues that all markets in all ages work alike. He argues that there is as he says,"a spontaneous internal life."(pg 241) inherent to every market. He sites his study of cotton prices in which the degree of wild swings remained the same over a century. Which I believe means the volatility.

So I don't think using 1920's german inflation is out of line at all if you agree with his initial argument.

[ QUOTE ]
His "strategy" of buying options on events 3 or 4 standard deviations from the mean...
Is unworkable in real life...
Because if a Risk Savant was dumb enough to sell you such options...
And risk bankrupcy...
That Savant would probably charge you 10 to 100 times Fair Value

[/ QUOTE ]


Didn't one of Taleb or Soros "friends" do exactly this and go bankrupt?

you also say [ QUOTE ]

Focusing on one bad player in a game full of strong players...
Is some sort of common logical fallacy...
But I forget the specific term.

[/ QUOTE ]

Actually if the player is really bad this is often exactly what happens. Haven't you ever heard about the stud game with Larry Flynt? They all quit when he's not playing.

[hapaboii]

Sorry dude, but I find it hard to believe that you've managed a fund for the past 15 years. Perhaps you are an independent trader, but I can't believe someone with a strong institutional background would make some of the comments you've made. No offense though, I don't think that means you are somehow worse off for it.

You said that Taleb's blabberings are common knowledge to options pros and that you'd recommend FBR to newbies. You are right in that Taleb is just a marketer who has created his own little niche by espousing crap through his writings.

I'd say that most practicioners realize Taleb champions the very useless strategy of buying deep OTM options on the assumption that the market underprices them. So he likes to bleed to death. We saw how well that went with Empirica. Proponents might argue that this doesn't prove his strategy doesn't work - they will say that given enough time, if all these far OTM options are underpriced, then in the long run you are +EV to buy them. There's no denying that deep OTM options are hard to price, and as such, often mispriced, but I don't think one can say that they are always or even generally underpriced.

I won't guess at the statistics but I do agree that the majority of hedge funds are skimming ops or something of the like.

Regarding liquidity and efficiency, I think you are right. In general, the more liquid, the more efficient. But there are definitely trading edges to be had in liquid markets. Pseudo market-making black boxes in liquid futures markets come to mind.

If you think corruption and insider trading in the US is bad, look at international markets. The US is probably the least corrupt.

Oh and on a side note, isn't Elliot Wave based upon fractals? I think RN Elliot beat Mandelbrot to the punch.

[DcifrThs]

[ QUOTE ]
[ QUOTE ]

hedge funds and other large money managers...


[/ QUOTE ]

Probably 90% of "hedge funds" are designed to be "skimming operations"...
That is... the principals know from the outset ...
That they have no chance of outperforming the market...
Except by pure luck...
But they cannot lose financially...
Because of the fee structures and the operation of multiple funds.
Losers are shut down... and the winners keep just on "skimming".

[/ QUOTE ]

i certainly appreciate that. i don't know the stats...but that isn't where that quote you took from me came from. i was agreeing about the problems large funds havewith investing in small cap stocks or illiquid markets.

[ QUOTE ]




[ QUOTE ]

i'm shocked that you mistake liquidity for efficiency so readily.


[/ QUOTE ]

There is a very high degree of correlation...
Between liquidity and market efficiency.


[/ QUOTE ]

that is absolutely true, but it doesn't mean you can or should mistake the two.

[ QUOTE ]


[ QUOTE ]

i was asked about this in some other thread. the question was, "i hear currency markets are the most liquid & thus most efficient and nobody can beat them, is that true?"

well, it most certainly is not.


[/ QUOTE ]

This has to be viewed differently.

Money is not "pulled from the ether".
When you make money in liquid markets...
You are TAKING IT AWAY from a Professional Traders.
As with all Zero Sum Games...
There will be about 5% winners and 95% losers.


[/ QUOTE ]

i don't think you read my post. alpha markets are zero sum. 100% correct. but when ONE player is a MASSIVE loser ON PURPOSE, you have an inefficient market with significant opportunities for profit.

if you have 10,000 players who have a total of $100 invested and the 10,001st player has $1,000,000 invested and is doing so without regard to profit, you can make a ton of money off that ONE person. 95% winners vs. 5% losers isn't the problem. the dollar distribution is what counts. that one big loser can feed the other winners.

[ QUOTE ]


[ QUOTE ]

the UK IL bond market's real yields are artificially low (and thus BEI artificially high) because it is mandated by the govt that all pension fudns must match liabilities & assets to some degree or other (i forget the actual reegulations). that said, the UK IL bond market is one of the biggest available to trade (though has recently been overtaken).


[/ QUOTE ]

Focusing on one bad player in a game full of strong players...
Is some sort of common logical fallacy...
But I forget the specific term.

[/ QUOTE ]

but again, when there is one (or many) bad players in a game full of strong players and that one bad player is losing ALOT on purpose, you have a big inefficiency that can feed many of the "good" players or "pros."

now, not all markets are like currencies that are pegged and eventually will burst though a peg.

but the point is that there aren't just professionals making it impossible for you to make money in the markets. you can still make money in the most liquid markets. period.

you just have to pick your spots. day trading US 10yrs aren't a good idea. but when you find inefficiencies that even the best pros are missing, you can pounce.

back when 10yr yields were at 4.6% in the first quarter of this year, that was a massive inefficiency. one that i profited off of along w/ many others. some contributions to that imbalance were foreign central banks disproportionate desire for dollar assets (which has waned) and the majority of players thinking the fed would cut rates when rates were already artificially low.

spotting that imbalance (in that HUGELY liquid market) provided a profit. even at 5.02% i'd be short, just not as strongly.

POINT: you can make money in liquid and efficient markets. i feel you have too strict a view on the inability to beat the "professionals" since you aren't taking money from the "pros" in most profitable circumstances. there are other players in the markets (i.e. what contributes to backwardation in agriculture markets? answer: hedgers selling their product forward without regard to price to some extent. they just want to hedge their future earnings and not be at the mercy of volatile markets.)

[ QUOTE ]


Barron,

As if beating efficient markets against strong opponents was not hard enough...
I'm not sure that you realize the DEGREE...
Of corruption and cheating and insider trading, etc...
In the US financial markets.

It's rampant... click on this:

http://www.google.com/search?hl=en&q...=Google+Search

I get cheated every day...
But it's just the cost of doing business.

Regards,

rm+

[/ QUOTE ]

ummm, ok... equity markets cheat, wonderful. since i'm not involved in equity markets for the most part i don't really care that much.

i'm sure insider trading is more rampant than just in specialist firms. think about all the options spikes we've seen before takeover announcements. and all the things we DONT see or catch.

i hope my post is clearer and you read in as i wrote it.

thanks,
Barron