The New Market Wizards: Conversations with America's Top Traders (46 page)

Well, I think I can answer that for you. The standard mathematical curves that allow for specific probability statements just don’t look that way [i.e., don’t have fatter price tails].

I think that probably explains a lot of it, but it presupposes that reality matches the curve in a mathematician’s head. Believing that can get expensive.

Let me try another one. Standard option pricing models are price neutral—that is, they assume the most likely point is an unchanged price. Do your option pricing models differ by incorporating a trend bias?

They don’t, but I think some people believe that they do. There used to be a rumor that CRT gave this line about being price neutral and hedged but that we really made our money on direction. We didn’t try to dissuade people from believing that, because it made people more willing to trade with us. But now, since the cat is probably out of the bag anyway, I’ll confirm it. Our price models are neutral.

Hypothetically, let’s say that you developed a model that had a 60 percent probability of being right on the direction of the market. If you incorporated that trend projection, then your option pricing model would be skewed, and theoretically you could do better.

The obvious rejoinder to that question is that if you think there is a directional bias, set up a separate account to trade that idea, but in your option account, trade flat. You’ll get the same benefit, and if nothing else you’ll segregate the results due to each approach.

Do you believe that over the long run there’s an edge to being a seller of premium?

Not that I’m aware of.

Which do you consider a better predictor of future actual volatility: historical volatility or implied volatility? [Theoretical models employed to estimate an option’s value use a number of known inputs (e.g., current price of the underlying market, number of days until the option expiration) and one key unknown factor: the volatility of the market until expiration. Since this factor is unknown, all the standard option pricing models assume that the future volatility will be equal to the recent volatility. The option price indicated by this assumption is called the fair value. Some people assume that if the market price for the option is higher than the fair value, the option is overpriced, and if it is lower than the fair value, it is underpriced.

An alternative interpretation is that the market is simply assuming that volatility in the period remaining until the option’s expiration will be different from the recent past volatility, called the
historical volatility.
The volatility assumption embedded in the market price is called the
implied volatility.
If option prices are a better predictor of future volatility than is the recent past volatility, then the question of whether an option is overpriced or underpriced is not only irrelevant but actually misleading. In essence, the question posed above is equivalent to asking whether there is any reason to assume that the strategy of buying options priced below their fair value and selling those that are above their fair value has any merit.]

Implied volatility seems better to me.

Conceptually or empirically?

To me it seems pretty obvious conceptually. The implied volatility is a statement of what all the players in the market, having cast their votes, believe is a fair price for future volatility. Historical volatility is nothing more than a number representing past volatility.

In the early days of option trading, however, when the markets were highly inefficient, did you use a strategy of buying options that were well below their historical volatility-based fair value and selling those that were well above their fair value?

No, we didn’t even do it back then. We never assumed that the historical volatility was a reliable guide to an option’s true value.

How, then, did you determine when an option was out of line?

By making a bid/ask spread where you believed you could find some other trade to lay off the volatility risk and still leave a profit margin. We were making judgments only about whether an option was overpriced or underpriced relative to other options, not about whether it was mispriced relative to the underlying market.

There’s been a lot of time and energy expended in developing improved option pricing models. If the model-derived price is not as good an indicator of an option’s true value as the current market price, does it really make all that much difference which theoretical model is used to derive option values?

I think it does. You still need the model to determine relative values. In other words, you’re trying to determine whether a given option is overpriced or underpriced relative to other options, not necessarily whether it’s underpriced or overpriced in any absolute sense. If two models have different opinions about the relative values of two options, then the people using those two models are going to trade with each other, and they can’t both be right. Yet neither trader may have an opinion about whether a given option is overpriced or underpriced, simply about whether it is overpriced or underpriced relative to other options.

Do you believe then that your ability to develop option pricing models that provide more accurate measurements of relative option values than do the standard option pricing models is part of the explanation behind CRT’s success?

The models are important, but the critical element is the people. To make a company this size work like a clock takes extremely unusual people.

During the interview, three other CRT employees—Gene Frost, Gus Pellizzi, and Niel Nielson—had entered the room and now begin to par-take in the conversation.

How does CRT differ in this respect from other trading companies?

GUS: People who have interviewed here have told me that what separates us from other companies is that the other firms appear to be solely interested in their technical competence—their education and experience. CRT, on the other hand, also tends to place a large emphasis on the person and how well that person will interrelate with the other people in the work group.

What kind of people does CRT look for?

GENE: In the earlier years, we placed some emphasis on hiring the brightest people. One person we hired was a world champion go player. He had a great mind. It was like putting a human computer in the pit. One day he made a bad trade, panicked, and couldn’t bring himself to cover the position and admit he had made a mistake. He waited until the end of the day and still didn’t get out. Luckily, Joe caught the error at night, but it still ended up costing us $100,000. Even though this fellow was brilliant, he had a character flaw that allowed the error to get out of hand. Whether this guy cracked because of some insecurity in not wanting to look bad, or because of some other reason, in the end it comes down to a character flaw. Joe has made the comment that he would rather have a good trader he could trust than a brilliant trader he couldn’t. When we hire people, we look for three things: character, character, and character.

GUS: I think we try to hire people who are less self-centered and more team players than is typical for this industry. A lot of other firms may also use these words, but I don’t think they are as integral a part of the company as they are at CRT. It doesn’t mean that we always get it right, but just trying seems to have put us ahead.

JOE: I would describe our people as those who take as much pleasure in the success of their group as they do in their individual success. We’re not looking for people who sacrifice their good for the good of someone else, but rather people who can take pleasure in the success of the group. People with this attitude enhance the value of everyone around them. When you put together people who are not worried about whether they, individually, are getting enough credit, you have a tremendous advantage over the competition.

How do you identify whether someone is doing a good job if many people are inputting into the final result?

JOE: You can tell. The people who work with the person know, and you can ask him and he’ll tell you. I recently spent some time reviewing an employee at CRT. He had written out pages of information showing what he was doing and an outline of his priorities. After about an hour of this, I finally said, “Look, how do you think you have been doing? How would you rate yourself? Not how busy have you been. Not how hard have you worked. But how have you really been doing?”

He thought for a minute and said, “Well, I think I should have been fired.” He proceeded to give me an honest evaluation, including his shortcomings. He knows how he’s doing, better than if I were looking over his shoulder, and he really wants to do the right thing. In general, if I trust someone to evaluate himself, he’ll do so and tend to be his own toughest critic.

Look, not everyone may have the right talents to do the job properly. Someone can come in here and sincerely say, “I love the idea of CRT and I want to be a team player,” but still lack the innate talent to do the job. Or a person might think he can do the job and find out later that he can’t. Maybe he’s not quick enough, or maybe he’s too emotional. That has to happen. How do you deal with that type of situation in an organization like this?

JOE: Just like you do anyplace else. But the difference is that if the person is not self-centered, it’s so much easier to find out that he’s not right for the job. He’ll admit it so much more quickly. When you get the right type of person, and he finds out that he can’t do the job, he’ll come to you.

Do the other people on the team sometimes come and say, “This person is just not working out”?

NIEL: Sure, that happens. But when it does, there’s a very strong effort to find a place somewhere else at CRT for that person. That has happened over and over again.

And does that work?

NIEL: When we have a person whom we believe has the right type of attitude, it succeeds far more often than it doesn’t.

What distinguishes traders who succeed from those who fail?

JOE: Successful traders tend to be instinctive rather than overly analytical.

Why is being analytical detrimental to being a good trader?

JOE: Because it seems to mask intuitive traits and abilities. In fact, the most analytical people tend to be the worst traders.

What other traits distinguish the good traders?

JOE: Humility—the ability to admit when they’re wrong.

Doesn’t the fact that there’s more competition from other sophisticated firms doing the same type of trading strategies cut into your profit margins?

GUS: It has. The margins are a lot thinner than they used to be.

How do you handle that?

JOE: The margins go down, but the volume goes up. Also, in any business, the profit margin shrinks only up to a certain point. The margin can’t shrink so much that an efficient person in that business can’t put bread on the table. Therefore, if you can be the most efficient, there should always be a profit margin—maybe not all the time but certainly over the long run. I believe that’s true of virtually any business.

CRT is the preeminent firm of its type. What makes the company different?

JOE: At CRT we believe in the philosophy that people work best when they work for each other. People think that CRT’s success is due to some secret computer model. However, I believe that CRT has succeeded because we build teams. We try to give people a lot of authority and pay them what they’re worth. I’m often asked what is the reason for CRT’s success, and I’m willing to tell people because (A) they won’t believe me and (B) even if they did believe me, they couldn’t train themselves to do the same thing—to trust people and to give up absolute control.

Other people who do this type of trading often approach it too mechanically. People who are mathematically oriented believe that if you can just get the formula right, it solves the whole problem. It doesn’t. Most businesses tend to think that you work with one brain and a whole bunch of mechanical executioners. To build a machine that uses many different brains that are qualitatively contributing different things is an art. Most people don’t want to do it that way. Usually someone wants to believe that it’s his thinking that is making things run, and there doesn’t tend to be sufficient credit or responsibility given to other people. That’s not the way things work here.