Fatty Fat Fat

As a follow up to my note about VXX and VXZ, the new Barclay’s volatility ETN’s, here’s a fun riddle.

Background Information

VXX tracks an index designed to represent a constant maturity VIX future. The index it tracks can be replicated by constantly rebalancing a portfolio of front month and second month VIX futures contracts. The portfolio held will ALWAYS be some combination of front month and second month VIX futures contracts.

On Mar expiration, for example, the VXX replicating portfolio holds a portfolio containing 100% Apr futures (1 month VIX future portfolio). On the next day (Mar expiration + 1), a portfolio of all Apr futures is now a “1 month - 1 day” maturity VIX futures portfolio. Therefore, to hold the constant maturity, the portfolio must sell some fraction of Apr futures and buy May futures (that fraction is 1/”the number of days between Apr and May”). This continues every day until Apr expiration, when the portfolio holds 100% May futures, which is, again, the one month maturity VIX futures contract.

The VXX Riddle

Consider the following:

1. The VXX replicating portfolio is comprised of some linear combination of VIX futures.
2. It rolls every day.
3. Eventually, the VXX replicating portfolio will be comprised ENTIRELY of the some future beyond the current 1 or 2 month out VIX future.

If you sell VXX in a downward sloping term structure and buy the far dated future, the replicating portfolio of the short VXX will ultimately become 100% invested in the exact further dated future that you initially bought. VXX roll strategy guarantees an evolution from some near term future to a further dated maturity future.

Given that we currently have a downward sloping VIX term structure, one might consider selling VXX (whose replicating portfolio is composed of all Feb and Mar VIX futures valued between 46 and 48) and buying some future maturity (say May futures, for the price of about 38), then wait for the future date of futures contracts you bought to become the VXX deliverable. Trade out of your entire position.

Get rich? Obviously not, or I wouldn’t be posting this. So the question is: Why?

Hints:

• http://www.cboe.com/micro/vix/vixtermstructure.aspx
• http://www.ipathetn.com/VXX-overview.jsp
• http://seekingalpha.com/article/116352-proposed-vix-etns-are-not-a-volatility-bet?source=commenter

To encourage any smart people to play, I’m offering a prize for the best answer/explanation to this riddle that is delivered to my inbox by Thursday Feb 26, 11:59pm EST.

Feel free to discuss in the comments. I’m not really sure what the prize should be, but I do have a $25 best buy gift certificate lying around. If I can’t think of anything else, I’ll default to that as a prize.

For the love of God. Our system is so messed up.

Freakonomics author wins defamation suit:

Freakonomics author Steven Levitt will not have to pay a dime to fellow economist John Lott after a federal appeals court ruled last week that the best-selling book did not defame Lott.

Lott, a former University of Chicago visiting professor, sued Levitt in 2006.

Lott is the author of More Guns, Less Crime, which argues that allowing people to carry concealed weapons reduces crime. Lott claimed Freakonomics defamed him with this passage: “When other scholars have tried to replicate [Lott's] results, they found that right-to-carry laws simply don’t bring down crime.”

The federal appeals court in Chicago found Levitt, a U. of C. economist, was simply criticizing Lott’s theory, which is permissible.

For the love of God. I hate that our system is so messed up. It genuinely infuriates me that this is even an issue in America.  Getting sued for criticizing someone else’s work in writing is ludicrous.

If your only mechanism for supporting your ideas is litigation, maybe you should think of some better ideas. Levitt, as far as I can tell, wasn’t even really criticizing so much as putting an observation that others have been unable to replicate the findings of another researcher. Science requires independent confirmation by peers and replicability to really be of any value (yeah, economics isn’t a science…)

Commentary on / link to original lawsuit mentions:

The lawsuit may come down to the allegation in paragraph 13 whether the phrase “replicate Lott’s results” has an “objective and factual meaning.” Levitt will either try to persuade a court (or, if necessary, a jury) that “replicate” was used in its lay sense, rather than the technical sense.

That is some trivial bullshit. Don’t even get me started on the legal system and the stupidly litigious nature of our culture. How many billable lawyer hours do you think were allocated to this problem from both sides of the complaint? Anything more than zero is too many.

Worse is the fact that  it may come down to a disagreement about what the word “replicate” means in a NY Times bestseller. Those books are written for the masses! They’re dumbed down! Freakonomics was clearly not a technical book.  If authors had to worry about the context of every word printed in a 250 page book for fear of getting sued, pretty soon no books would be written. And then we’d just accelerate our decline to the dumbest first-world nation on earth. Disincentivizing education for the masses is a BAD IDEA!

The fact that a person would have to defend himself in court because some moron had to resort to the federal court system to validate his “research” makes me want to vomit. All over Lott’s face.

American’s are getting soft. Some of us need to grow up. And I didn’t even really like Freakonomics…

Barclay’s recently introduced two new Volatility ETNs, VXX and VXZ, which track a 1 month and a 5 month VIX Future.They trade just like ETFs or individual equities and are being touted as a great way to trade volatility (http://seekingalpha.com/article/117869-vxx-vxz-etns-allow-you-to-buy-volatility).

Barclay’s guarantees NAV for redemptions based on the Index it tracks every day (less fees). However, ETN’s have credit risk. These are unsecured debt instruments that track some combination of VIX futures values. As such, valuation should probably include some sort of discount based on Barclay’s credit worthiness.

When Barclay’s credit got downgraded last week, that should affect the ETNs pricing (It didn’t change its market trading price, as far as I could tell). An interesting thing about it is that since Barclay’s guarantees redemptions based on NAV as determined by the index value, they’re guaranteeing a payout that is independent of their ability to pay back this note. That’s essentially a claim about the valuation of Barclay’s credit default swaps.

Since the index pricing is well defined in the prospectus, its possible to replicate the index yourself. Imagine VXX without any management or trading costs. Replicating/Hedging this thing looks something like:

VXX = replicating the index using a portfolio of VIX futures - Barclay’s credit default.

Since Barclay’s credit default is not in the index equation, and Barclay’s guarantees NAV,

VXX= replicating the index using a portfolio of VIX futures only, so Barclay’s credit default risk = zero.

If you buy VXX thinking it should be worth the tracking portfolio of the futures, you just synthetically sold Barclay’s credit default at a price of zero.

Nowadays you should really consider that non-zero probability of Barclay’s credit default. As that probability rises, I’d like a risk discount to buy any of that stuff. Alternatively, being short this stock is synthetically (theoretically) being long Barclay’s credit default for free.

Relevant links:

• http://en.wikipedia.org/wiki/Exchange_Traded_Notes
• http://soundmoneytips.com/article/25162-etns-useful-but-watch-out-for-counter-party-risk

There are a lot of homeless people where I live, and it occurred to me that panhandlers asking for money on the streets are going to get hit hard.  A lot fewer people are going to feel compelled to give cash to strangers in the future.

Wine is an acquired taste. Children, as a general rule do NOT like wine when they first taste it. Young adults go out of their way to like wine so they can fit into society. They take wine tasting classes to appreciate wines. Appreciating wines, for the most part, is the process of training your palate to fit in with society’s general consensus opinion regarding which wines are “good”. This involves a fairly long process of wine purchasing/tasting that ultimately leads to being able to identify “better” wines. *

People are rewarded for this in all sorts of ways: we pay people to pick expensive wines for us, the psychological reward for knowing you carry expertise/knowledge that other people value, the superiority you feel over others (snobs, or oenophiles, as they like to call themselves, probably deny the existence of this phenomenon). Fear of being judged by people who do know about wines is apparently a large driver for many middle class professionals to teach themselves about wines. There’s a certain romantic appeal to wine culture as well. For all sorts of non-economic reasons, it is a skill to which our society has assigned value.

As it turns out positive reinforcement can do a lot to shape your taste preferences. People develop similar tastes and covet the same wines.  A disproportionately large number of people ultimately end up seeking a disproportionately small subset of the wine universe. They have systematically increased demand for a product they initially did not like by training themselves to like it; and since they’re consuming it, they’re also decreasing the supply of it, and thus every sucker in the game is a driver for price. At the heart of it, we are a society of people who have gone out of their way to train their palates to enjoy progressively more expensive wines.

Wine has gotten out of hand. Why bottles trade for hundreds of thousands of dollars is beyond me. At some point, its no longer about the wine itself but the story. Rarity. The biggest collection. The oldest wine. The last of a particular vintage. From Thomas Jefferson’s collection. These wine bottles accrue value due to demand factors beyond taste.

If people stuck to their guns, just drank wines they liked and found their own preferences instead of taking classes and reading books about what other people liked, the demand for specific wine bottles would be more dispersed.  Not only would everyone pay less for their wines, the discovery process would probably be a hell of a lot more fun.

Narcotics make way more sense to me. People actually like them, so they do it again. There might be some element of “trying to fit in”, but the major driver or re-use is the memory of the experience itself. And it might even cost less than a wine habit.

* It is my entirely unscientific observation that wine culture in Europe deviates significantly from ours.

Very interesting and dire. Does not bode well for the future of US equity markets.

Original URL: http://www.elitetrader.com/vb/showthread.php?s=518cfc775cacf467fa3349a83ab693b8&threadid=128320&perpage=6&pagenumber=1

How much would you pay to play the following games?

Game 1:

Take a randomly shuffled deck of playing cards (26 red, 26 black). I will reveal one card at a time until you stop me and tell me that you’d like to bet $10 that the next card will be a red card.

You pay the fee to play before the first card revealed. You get to bet once only. If the card is red, you receive $10. If the card is black, you lose $10. You are not required to bet, but once all cards have been dealt, you are given no more opportunities and no refund is given on the fee to play.

Game 2:

The same game as in Game 1, but instead of betting that the next card will be a red card, you are given the option to select the color of the next card that comes out. If you correctly predict the color, you are paid $10. If you are incorrect, you lose $10.

Basically, “What is the value of the option to select the color?”

There are plenty of fun variations that get progressively harder. I’ll get to them eventually.

In early 2008, I thought the markets were headed south. For the life of me, I could not understand how equity markets were being propped up, so I bet against them.

Being short the market when the general trend is down feels great, but it’s really easy to lose your resolve when time after time, Bernanke and Co. try to lift markets up.  The thing that I couldn’t weather was the nagging sensation that whatever wins I took, there would be some press release that came out shortly after: emergency rate cut, coordinated global rate cut, capital infusion, letting investment banks borrow from the discount window, new legislation, etc. I never thought it was the Fed’s job to uphold equity markets, but that seemed to be what it was trying to do, and punishing me every time. I was still up on the year, but I was starting to believe that it was just a matter of time before I got burned for leaning short.

Finally, I caved. I got flat the market and began to wonder what it would take for them to collapse. Even after Bear Stearns went under, I kept thinking, “This is it?”

But Bear caved, then bank after bank. S&P 500 futures down 100 points. Well, hadn’t seen that before. And Again. And Again. And volatility at its highs. I couldn’t stay away from selling that vol. S&P volatility on a 50? Unreal…

So I made the big play. All or none. “I’m young, I can afford to lose,” I told myself. Though I really meant, “I’m young, I’m smart, and I’ll be retired since I’m right.” Traders have ego problems, especially all of them. If traders didn’t believe they were smarter than the market in some way or another, they wouldn’t be trading.

But seriously, S&P500 under 1000 seemed absurd. Time to get long and sell vol on a 50 vol. Oops. With the VIX cresting over 80, those short volatility bets didn’t seem so good anymore.

Lesson to self: Don’t bet the farm unless you’re prepared to lose it. And I did. I wasn’t prepared to lose it. Let me tell you something — Losing well into the 6 figures in under a week can mess with your head a bit. I knew what I was getting into. I had rationalized before putting on the trade that I was risking my money for a chance at a really big payday. That sounds great if you win, but when the small chance you bet against comes true, it blows. And it did.

In truth, as my friends around me also lost money, I didn’t even talk about it. First, I couldn’t. Now that the unlikely had occurred, it seemed like a really stupid bet to have made. Success is the only thing that separates idiocy and genius.  I had lost multiples of what most of my peers lost.

I also didn’t talk about it because it didn’t even feel real. The money in my brokerage accounts never has felt real to me. I’ve never seen it, touched it, thought about spending it on a big screen TV. But the reality that losing it meant working for the man for longer was very real. And that was the part that hurt.

I’ve always wanted to be self sufficient, an entrepreneur of sorts, able to walk away from my job or at least define my life on my own terms.  I’m young, I have no idea what it takes. What I did feel in the immediate aftermath was that I no longer could imagine being free of a regular job. I’d have to rebuild, and I didn’t think the next few years would be the easiest time to rebuild.

Most people say things like “invest conservatively, put it away, the power of compound interest/returns will make you retire comfortably.”  Frankly, I don’t want to outperform over time. I want money now. I’d rather have 2 million in my 20’s than 200 million when I’m 65. I don’t care about future values or present values of my portfolio. I do know that I’d do a lot more with 2 million dollars today than 100 million when I’m old and crusty (sorry if you’re 65, I’m sure you’re not crusty, but I probably will be when I’m 65).  In either case, I think present valuation is a terrible way to look at it. Happiness is a maximizes utility faster than dollars, and I can think of fun ways to live the rest of my life if I had 2 million today.

I thought about ways to get it back, but really, I was shell shocked. I didn’t have the guts to put on risky trades, and I wasn’t making money anymore. So I pulled out for the most part and told myself to wait for good opportunities before diving back in.

I started watching my personal finances more, seeing where I spent, and what I was spending on. I didn’t consciously make the decision to, but after losing a lot of money, I became much tighter with my spending. And I realized: I don’t spend that much. If I pare down a little bit, I still DO have enough to retire myself. It’s not much, in fact, an embarrassingly small amount for someone who thinks they can retire, but hey, I’m a frugal guy.

Retirement to me isn’t sitting on a beach doing nothing, retirement is doing what I want, working on cool, challenging projects, and being happy. And it took me losing the bulk of my money to learn that I already had that.

The problem is that trading can get to be an endless rat race of sorts. Trading has a very tangible, quantifiable, objective goal: to make more dollars. Whatever money you have, if you have more next month, you’re doing well. I hadn’t defined my exit strategy, and all I knew was I wanted more.

After losing big and finding that I somehow still had everything I wanted and everything I needed, I was surprised, confused, and delighted; I realized that I don’t really need all that much money. If I hadn’t taken that hit, I might have never figured that out.

We all start as slaves to corporate America.  We toil, we accumulate savings, we buy our freedom. Its not about whether you do walk away; As long as you can’t walk from a job, you’re still a slave to the machine. I don’t really have enough that I’d want to walk; but when I realized that I had enough that I could walk, I was freed. A slave to corporate America, buying his freedom.

I’m happy with what I have now, and I don’t know if I need to risk any of it.  I’ll still work because I like it, but there’s nobody shackling me to a paycheck anymore. I still love finance, I think its fun and challenging. I certainly don’t mind more dollars in the bank, but realizing that I have enough to walk was liberating beyond description.

Suppose I offer you a game in which  I randomly pick a number from 1 to 100, inclusive.

I offer you the chance to guess the value of the number, and if you guess correctly, I will pay you that quantity of dollars.

For example: the randomly selected number is 64. You guess 64. Then you would win 64 dollars. Note that the number is randomly selected, so the person administering the game has no control over what number is chosen. They can be assumed to be drawn out of a hat.

Question: What is the largest sum of money would you pay to play this game?

Variation: In this variation of the game, instead of being required to pick the correct number, the player wins if he chooses a number that is within 10 of the random number. i.e. if{abs(x-rand_number) <= 10} then {player wins sum of money equal to x}. How much is this game worth?

Option valuation, and really all equity market plays are implicitly statements about the belief or non-belief in probability distributions or odds implied by the marketplace. Buying an equity implies that you think the market has undervalued an asset (i.e. the probability that the asset will be worth a greater than the forward price is greater 50%).

People who tend to be good at math, probability, logic puzzles, and understand these sort of games of chance tend to also be good at the sorts of questions that some traders are interested in as well. And traders might all be compulsive gamblers (maybe, if we are to believe any of the books about Wall Street, anyways).

I just returned from a long trip to Japan, and I have a few brief observations.

Paper Napkins

What is going on with their napkins? The napkins at the restaurants are, (1) itty bitty tiny pieces of paper, and (2) water resistant. I felt like every napkin was part paper-part plastic. Or imagine taking one-third of a regular U.S. McDonald’s napkin, ScotchGuarding it, then using it. Wiping my mouth just smeared things to the other side of my mouth.

Remember the Bounty Paper Towel commercials — instead of soaking up the puddle of water by placing the napkin on it, I imagined that Japanese napkins would just float on top, repelling the water.

Actually, this isn’t really so much of a complaint. I guess while America’s top minds were working in Proctor & Gamble’s Research department engineering “40% more absorbant, 25% more resilient” paper towels, Japan employed their engineers in advanced technology. For example electronics and…

Toilets

Seriously. This is beyond explanation. There are way too many buttons on their toilets. I was a bit curious about the “Bidet” button, and told myself that I’d work up the courage to try it before I left, but alas, I lacked the bravery to face the unknown toilet button. And heated toilet seats are quite nice.

Face Masks

A disproportionately large percentage of the population wears face masks (the kind a surgeon might wear), supposedly to protect against germs or to prevent spreading their own germs, which is actually quite considerate. The first usage sounds like major paranoia to me, and probably of dubious efficacy.

Trash Cans

There are barely any trash cans. Anywhere. And there is barely any trash anywhere. It amazes me that an entire society of people can be more or less organized to carry their trash until they find a receptacle. And when they do find said receptacle, there are 4 compartments for: PET  bottles, glass bins, combustible trash, and “other waste”.

So Fresh and So Clean, Clean!

Tokyo has to be the cleanest big city in the world. I saw two girls scrubbing an outdoor escalator with toothbrushes. TOOTHBRUSHES!!! OUTDOOR!!! The outdoors, are, by definition, dirty!!! TOOTHBRUSHES!!! And a poor guy scraping gum off a trash can in a department store. Tokyo is pretty much as clean as a big city can get.

Illusion(?) of Safety

I was jetlagged and ended up exploring parts of Tokyo late at night a few times. Shinjuku, where there were lots of people, Shibuya, Harajuku and Yoyogi Park too. Also more desolate and quieter places near Shimbashi, Kappabashi, and a few others. Lost visitor walking around exploring, at 2 am. Not once did I feel unsafe. Maybe I was being stupid and just didn’t realize what I was getting into, but I sure felt safer than I’ve felt in other cities. I sure don’t walk around Central Park in the middle of the night too often.

Public Transportation

Trains are awesome. The boarding platforms have little arrows that indicate where the doors will be when the train stops. And the trains stop within a foot or so of the indicated spots.  Buses to and from the airport run on time, to the minute. And its all really clean. And people are polite and don’t yap away on their cell phones loudly on crowded trains and buses. Amazing.

Social Criticism

First of all, great place. I wouldn’t mind moving there for a year or two, to really get the feel for Japan. I was in Tokyo, and I can see how people might relate it to another big city, like New York, London, or Hong Kong. But at the same time, it has a distinctly different vibe. I can’t describe it, won’t try to, but all I know is that, whatever it was, I liked it a LOT.

It’s not the cleanliness, the generally pleasant demeanor, the way that people seem to be comfortable with who they are. Sometimes I feel that Americans (myself included) communicate a sense of entitlement, and that they haven’t been given their due. Not a pleasant vibe. Fast food chain employees in Tokyo treated me very differently (positively and cordially) than I’m used to be treated by fast food workers in New York City.

Granted, I experienced a very small slice of society and I don’t even begin to claim to understand the culture difference, but that was my impression. Obviously there are really complex issues that go far beyond what I’d even pretend to have seen or experienced in my short visit.

Maybe people were just putting on a happy face for an obvious visitor. Maybe it was all fake smiles and they turned around and hated me. You know what? Ignorance is bliss, and I’d rather be fooled.

Can’t wait to go back for a longer stay.