Options Trading News

Our world is increasingly dominated by formulas, but blind allegiance to them causes more trouble than good.

Although models can be useful, even necessary in many realms, they must be used with a healthy dose of common sense and perspective to provide real value and avoid unintended consequences. They are, for example, at the heart of JP Morgan's issues and some that are closer to home.

Yesterday my 5-year-old son went to get a checkup at the doctor's. (Bear with me, as this does have a valid point for trading.) It turns out he is in the 50 percentile for height and the 80th percentile for weight. As such, his body-mass index says that he is overweight.

I acknowledge that such a formula is useful as a basic screen. Obesity is a serious problem in this country, and increasingly so among children. But here is where a little reality should step in.

My son is extremely active. He is "big-boned," wide and strong. And he is not overweight. One good look at his body would make that obvious.

Presumably the doctor was paying attention when she examined him, but she still pressed us about his diet: "Too much milk?" "Too many fried foods?" So apparently the blind allegiance to the model won out over common sense and perspective.

The problem, of course, is the same in the financial world. We expect the experts to be smart enough to apply models sensibly but, sadly, that is often not the case.

The quants that are coming up with trading models are, according to many who study the matter, not very good in common sense and broader context. And the big-wigs who get handed the models don't understand their premises well enough to have any perspective either.

While the formulas may tell us little about the real world, they do tell us a lot about the underlying assumptions of those who created them. In the case of JP Morgan's $2 billion loss, the model in question took the form of "Value at Risk" (VaR) calculations.

Others have detailed the flaws of the VaR concept, but I will simply say that all models are rough approximations of the real world and tend not to hold up on the fringes. I don't have an inside line, but it certainly appears that JPM was doing its best to profit from their "hedging" activities--something that is difficult or impossible to do, depending on whom you ask.

Although that can be a real problem, especially for a bank like JP Morgan, it can also be a potential source of profit as long as you fill out the rest of the equation. My personal edge in trading lies in having a basic understanding of the models and then applying what little common sense and perspective that I have.

I look at what these formulas say and what their underlying assumptions are. Then I look at reality and the way the world actually works, which is far more complex than any model can calibrate.

Often there is a way to capitalize on the difference in a little bit of reality arbitrage.

(A version of this article appeared in optionMONSTER's What's the Trade? newsletter of May 16.)