Jan

3

When magic of the markets is felt every moment, why is there no organized market for magic?

For New Years Eve, one chose to be at the Mela restaurant, (Mela a word from the Indian vernacular means the village fair). Among a host of activities from a village fair, the restaurant specializes in bringing a personal magic show to your table for a small fee, and the question arose right there at the dinner table as to why is there no organized market, not even a national or trans-national company that specializes in retail or wholesale magic?

There are several national and international companies with listed stock in the arena of restaurants, hotels, movie making, movie screening, bowling alleys, vacation organizing, vacation sharing, culture companies, etc., but there is not a single listed stock or organized magic company. Why?

Here are some possible explanations:

Many more ideas come to mind, but then the thoughts have stayed lingering around this one point about being personal. All other human endeavours in the arena of entertainment and services that have been able to overcome the personal factor and lend themselves to being productized, standardized, predictable, mass-emulated, mass-transported, mass-communicated etc. have come to evolve into giga-corporations. Individualistic personal pursuits of acting, dramatizing and magic have failed to turn the magic of the markets to their advantage.

So, is the magic really in the crowds rather than in the magic itself. What important lessons could one derive from the failure of magic to draw the magic of the markets to its advantages?

Easan Katir adds:

This weekend I had a front-row center seat amidst a sold-out house at the Geffen Theater in L.A., to view up close a talented sleight-of-hand master, Ricky Jay and his 52 Assistants, directed by David Mamet. Consequently, I have been contemplating similar corollaries between the conjuror’s art and the trader’s art. Certainly there is plenty of misdirection and deception in both arenas. There is also plenty of explanation to convince one that the impossible is normal. Mr Jay produced winning poker hands, and explained that a card cheat must not only give himself a good hand, but give the suckers good enough hands to inspire them to stay in the game.

Steve Ellison offers:

An important parallel between magic and the markets is the role of patter in distracting customers’ attention from the sleight of hand. A thing to which a magician is drawing the audience’s attention is almost certainly not the main event. The weekly enumeration of reasons to be bearish is an example of market patter.

Laurence Glazier comments:

Magic is also a matter of political or sociological point of view. Is our very existence magic, or the random walk of chemicals? If I construct a chord progression which moves the e-motions, is it science or something more? The magician who bends forks and keys - the process often continuing after after he has ceased touching them - wil never convince the “component parts” of science, and likewise neither would those who have vibhuti.

I am not sure that music works well in the market - where it is there the market - a la Adorno - may affect it adversely, and similar considerations may apply to real magic. If life is to be magical, it must have magical qualities. It is easier for children to see them, though, so let’s stay young.

Andres Vincent counters:

Forgive me for disagreeing, but DNA strands, crystal organization, life itself, a snow flake, clouds, animal life, glass, light, rainbows, electromagnetism, classical mechanics, relativity, etc., etc.. The whole universe is magical, so to see magic there is no need to hallucinate. Just read the book of nature. But to appreciate this beauty its complexity must be (at least a bit) understood, i.e. we have to observe, to work, to learn — in other words, try to become adults.

If adults stay young, and that’s unfortunately the case of the majority, the only magic provided today is overconsumption and/or religion, i.e. deceptions.

Bruno Ombreux mentions:

I would add geology and botany to your list. I got undergraduate classes in both of those, an it is incredible what learning about these subjects does for you.

After studying geology, for instance, one sees the world in a different way. Walking in the countryside — you don’t see the normal countryside any more. You can see how landscapes came to be, you can see millions of years of evolution, movement, shocks, erosion, chemical reactions. And you don’t see rocks anymore, you see names.

You can call a stone by its true name, that is magic. It actually kills all the poetry of a walk in the countryside though, so I am glad I forgot my geology classes.

Dec

21

One must repeat that the unconditional drift of the market is 10% a year. Whenever you are short, you have a drift going against you. When you wish to go short, chances are that the drift of the market will be above 10% a year. That’s because you and others think there’s a bear market retrospectively, and require a higher rate of return to be invested. In addition there are frictional costs to being short. Put them all together, and I’ve never seen a short seller who’s made money, nor has the Palindrome. It does give psychic value however in that it lets you vent your hatred of the system and yourself. It also gives stature because you are always on the negative which seems so much more poignant than the positive.

Since you always are giving away money on the short side, on an expectational basis, it is best not to consider it as the wind is against you unless you are truly insecure. The question of when you should go short is the wrong question. A better question is when you should increase the leverage of your long investments. I would propose a hypothesis that it is good to do that when the market has suffered a decline with a given period of a certain magnitude or more.

I believe the above reasoning, as well as the questions I ask bears about whether things are truly so much worse than before, and whether if they are, is this bullish or bearish, which I have made repeatedly since 1960 but also for the last four years, during which the market has doubled, has prevented many people from self destruction.

Dr. Janice Dorn provides a different perspective:

Part of the profundity of Victor’s remark is that the bears make poignant arguments which are almost tailor-made to touch something very deep inside of those who are always watching and waiting for some disaster or catastrophe. The bearish arguments tend to be more scholarly, detailed, laced with Latin words and appeal to the limbic core of the brain (which holds memories of fear and terror and sees them even in their absence), as well as the higher neocortical areas which are, in some way, hard-wired to process, consolidate and retain bad news more firmly and longer lasting than good news. Bad news is stored as pain and that pain can be evoked in almost any situation. Good news tends to be more fleeting and there is more difficulty reaching into the brain stores to retrieve the memories of euphoria. Perhaps the neurochemistry of euphoria (be it dopamine, serotonin, norepi, or any of the thousands of neurochemicals) is configured in a way as to be more transient, spontaneous and non-entrained. Depression, disaster, danger lurking around every corner is much more “reachable” in terms of our psyche. Once again, this is likely a function of the way that the cortical neuro-pathways are laid down and communicate electrochemically with each other in the vast cortical landscape.

In any case, the rah-rah cheerleaders are often seen as buffoons, whereas the permabears are the scholars and masters of Latin.

“A mass of Latin words falls upon the facts like soft snow, blurring the outline and covering up all the details. The great enemy of clear language is insincerity. When there is a gap between one’s real and one’s declared aims, one turns as it were instinctively to long words and exhausted idioms, like a cuttlefish spurting out ink”
–George Orwell, writer (1903-1950)

John Bollinger adds some numbers to the discussion:

S&P 500, 1950 to date, returns by month, ex dividends mean = 0.734%, standard deviation = 4.085%

Dr. William Rafter explains the professional’s dilemma:

Dear Mistress Market,

To second the chair’s remarks about the risks of being short, I emphatically state that “a friend” has never made any money on the short side of equities. Even in profound bear markets, the friend has gotten nothing but frustration out of the short side. Conversely the friend has been able to make money on the long side in those same profound bear markets. But the friend has a problem: people who hire his services want him to add a short component.

More than a quarter of the hedge funds pursue a long/short (”L/S”) style. Let’s assume that our friend had a very successful fully-invested long-only (”L-O”) strategy. The funds don’t want to employ his L-O strategy because they are under the impression that a market-neutral strategy of L/S is less risky. But our friend knows that the short side is just wasted; he can prove that his L-O strategy beats a L/S version of the same thing. By beating it, we mean in every way: higher Sharpe Ratio, lower drawdowns, etc. Now the friend is looking for an allocation of X dollars in his L-O program, but the funds only want to give him .3X or .5X. Since he clearly cannot make money on the short side, he has adapted by finding a strategy that will go nowhere - and that’s what he shorts. (He cannot short the index, because he knows that also will go up.) By his little charade he gets his full allocation, and the fees that go with it.

But this irks, as there are inefficiencies all around: extra transaction costs, risk of errors, extra man-hours, etc. Furthermore, our friend assumes that he is not unique. Others must have the same problem. With more than a quarter of the hedge funds using L/S strategies, how much is being wasted? Is our friend on ethical quicksand by giving the “professional client” what that client says he wants?

Sincerely,

“Puzzled”

Laurence Glazier asks if Optimism in the Markets Exists for More Simple Reasons:

Putting it very simply (or too simply?) is the positive drift in the market an inevitable manifestation of human potential and the innate cheerful optimism we all have, or at least were born with?

Scott Brooks provides his perspective:

I would say no.

Most people are not innately positive or optimistic. Most Americans are blessed by capitalism simply by accident of birth. If they had been born in a communist country, they would simply be sheep there (as they are sheep here) albeit much more unhappy sheep with a greater sense of hopelessness.

Growing up where I did and being surrounded by the people (and their negative destructive attitudes), I don’t think most people are innately optimistic. Any optimism they have is because they are surrounded by an environment of capitalism which breeds some optimism because here they are at least safe (no secret police to break down your door in the middle of the night), they are well fed (no mass starvation, or really, any starvation here), there is consistency of rules (rules and laws are not based on the arbitrary whim of whomever is in charge) and they can see that what is happening around them is consistent with what they innately know is the philosophy of life (as opposed to the propaganda they are exposed to in statist countries…innately they know its a load of cr-p).

No, people are not innately optimistic. Capitalists are. Think about it. What we have today is because of the skills and mind set of very few men. Rockefeller, Carnegie, Edison, Gates. Or men like Jefferson, Franklin, and Henry. Or scientists like Currie, Oppenheimer, Watson and Crick, or my uncle Bob.

What we have as a country is the result of just a few people who were truly optimistic and had the strength of character to fight through all the naysayers and negative busybodies (the Elsworth Tooheys and Wesley Mouchs, Dan Rathers, Paul Krugmans, Alan Abelsons, etc. of the world).

No, people are not optimists. They are negative pessimists who will almost always resort to the lowest common denominator of gossip, destructive thinking and thinking the worst of people.

Just a few of us actually create something of value in this world.

The rest of the world rides on our coat tails….and most of them are dragging anchors behind them or throwing rocks at the back of our heads, or climbing up on our backs to whisper in our ears all the negative things they can think of…but the nice thing is that on our coattails there is also an odd person or two (not very many mind you) who are glad to be on our coat tails…

They appreciate what the men of the mind do for them. And they fight the negative naysayers dragging anchors, throwing rocks or whispering in negativism in our ears.

They are known by many names…but most on this list would think of them as the “Eddie Willers” of the world.

Prof. Gordon Haave Disagrees:

No. The things you cite explain the growing economy. The positive drift is simply what the market pays you to part with your $$$ to put into volatile investments. In fact, the more optimism you have the less the market would have to pay you, so that would actually bring returns down, which of course highlights the important to us optimists of people like Abelson. If everyone thought like us, returns would be lower.

Dec

4

A chess player once told me that his purpose in playing was looking for the truth. A throw-away remark which stayed with me.

Time zones and the Pond enable me to spend some time composing before the Market opens. It is a quantum like world. One can start with virtually nothing, the simplest chord sequence like I V I. Then by opening a curtain from this “nothing” is revealed limitless opportunity to develop emotional themes and developments pursuant from the chord progression, each leading to other vistas. But — like a quantum measurement — the material is not available until noticed by the artisan, and is then fixed in its character, for ever affecting what is to be found next. Now what is more real (or more enduring - if these concepts are the same), the chair on which I sit or the musical ideas I thus frame?

Then comes the Market, another limitless sea. My spreadsheet securely lashed to the broker API, I watch the tide wash in and out, waves from each position move up and down tick by tick. I mainly watch the numbers change, using graphs only where it helps, and although I am now able to channel them into virtual reality I will do so only if/when it helps see what is going on. Some positions — generally the larger ones — are more prone to move up and down, and some more often than others, and this latter concept, a slightly different one from volatility, is not yet coming over visually.

It is a challenge to communicate the maximum meaning with the minimum components, which faces me every day in Music and Market.

Nov

27

I often ask myself what is the purpose of my trading. Yes, I know, I do it for the money, for the intellectual challenge, and all that. I also understand how the markets function by allocating capital and signaling value, etc., and how I am a small, small part of that. But I mean it from a different perspective. Having worked a lot with business planning (mostly with LOTS) in different companies, I often think of how I would characterize my reason for trading if I were to write it in a business plan format. If I sold some gadget for example, I would ask: What is the purpose of the selling of the gadget? Who benefits from it? What is the underlying reason that there will be a value gained from my selling the gadget, from which I can make a profit. I think that the same applies to trading. Furthermore, a good purpose should also function as a day to day rudder and make sure that I do not deviate from my niche. To do that, it should encapsulate what we should do, why and for whom. With a well thought out purpose, we should be guided both in our every day activities as well as our important long term decisions.

During the talk this year in Central Park, Mr. Wiz mentioned something that perhaps is not spelled out as a company or trading purpose, but which I nevertheless think was one of the best fitting purposes I have ever heard, as far as I understand the underlying thinking in the company. He said: “We provide the market with liquidity in fearful situations”. Well, it seems to have worked out quite nicely, and I think there is a lot to be gained by all traders from being very clear with what it is their niche is in the market, and spelling it out in a “trading purpose”.

Scott Brooks adds:

Providing the market with liquidity in fearful situations is tantamount to buying low. The flip side of this coin is providing the markets with liquidity during the great times, which is tantamount to selling high!

This is an investment philosophy that I invented years ago … it is called “Buy Low and Sell High” … (I know, you’re shocked, you did not know I was the inventor of “buy low and sell high”)

But seriously …

This was described to me by a college professor as the “good guy school of investing”. It works like this:

If someone wants to sell you something for far less than it is worth, be a good guy and buy it from them. Conversely, if someone wants to buy something from you for far more than its worth, be a good guy and sell it to them.

The “Good Guy School of Investing” is providing liquidity to the markets during fearful situations (and also providing liquidity when the party the market mistress is throwing is at its crescendo.)

In between, just take advantage of the long term positive drift!

Dr. Kim Zussman comments:

I recall Viktor Frankl’s Man’s Search for Meaning. His conclusion was that we are not in a position to ask life it’s meaning - life will ask you to determine it’s meaning.

Something like ‘what you get out of it is proportional to what you put into it.’ Even if you lose, or under-perform various benchmarks, you get to be ironic.

For some, trading has analogies in most aspects of the universe, and can become self-consuming. To others it is just money; and Buffett, Soros, Ken Smith, etc. all put on their pants one leg at a time and suffer the same frailties we all do.

Laurence Glazier contributes:

This brings to mind the great Armstrong lyrics:

If I never had a cent I’ll be as rich as Rockefeller Gold dust at my feet on the sunny side of the street [More]

So above all let us trade for the love of it! Trading is a two way process and equally important as our purpose is the realization that it shapes us, acting, like other arts, as a mirror.

GM Nigel Davies mentions:

Something I’ve noticed with many very strong chess players is that they don’t need to think about purpose, they are simply at one with the game. And one of the best ways to nobble a tournament leader is to congratulate him on his excellent play and ask what it is that he’s doing right (not that I’d use such a tactic myself).

Accordingly I suggest that one of the goals of mastery is get past the stage of awkward consciousness and discussions such as the present one. For a chess player it should be enough to say ‘I crush, therefore I am’, and the trading version would be ‘I’m profitable, therefore I am’. And the strategies required should be in one’s blood, things that are so well studied and deeply ingrained that one uses them as naturally as breathing.

Jim Sogi adds:

In Trading and Exchanges by Larry Harris of USC discusses why People Trade. People trade to invest, borrow, exchange assets, hedge risks, distribute risks, gamble, speculate, and deal. Understanding the reasons different people trade and the taxonomy of traders, including ourselves, allows understanding the opportunities that arise. Interestingly a smaller percentage of participants are true investors, and even fewer are speculators. Of those even fewer of what he terms informed speculators are the statistical arbitrageurs, of which we compose a small part. Oddly Many do not trade to profit but for other reasons. This is where the speculators purpose in the firmament comes in, and for which we are rewarded, to facilitate the other purposes of the other participants. They pay us for that privilege. Dealers are the ones who sell liquidity, not the speculators. The above does not answer the heart of Mr. Lindkvist’s query, but it does set the framework for the answer which must vary according to each of our purposes and which niche into which we fit in our respective operations.

Larry Williams mentions:

Years ago we did a personality profile at seminars asking traders to list the 3 primary reasons they traded.

None of them listed as the first reason to make money.

Answers were like, “Excitement, Challenge, to show my brother in law I’m smarter than him, etc”

Kim Zussman creates a masochist/self-loathing correlation matrix:

Long Only Bought Hold Sold
Too Soon -$ -$ -$
Too Late -$ -$ -$
Too Long -$ -$ -$
Long/Short Short Flat Long
Market Up Up/Down Down
Short Only
100 Year Return -1,000,000%

Steve Ellison comments:

There is a technique used in ISO certification called SIPOC. In this technique, an organization identifies its suppliers, inputs, processes, outputs, and customers (hence the acronym). The organization divides its processes into those that create value, triggers for value processes, and supporting activities that do not themselves create value for customers but facilitate value creation. This technique can help an organization articulate its value proposition and focus its processes on value creation.

Participating in a SIPOC exercise this week challenged me to consider how I might apply this technique to trading. A trader might create value in any of several ways, including providing liquidity, moving price closer to true value, assuming risk that others wish to avoid, and providing psychological relief by taking other traders’ losing positions off their hands.

Nov

20

In a land far, far away, almost thirty years ago, I worked on a mainframe with hundreds of terminals, and it occurred to me that I could write an OS script to enable users at different screens to have text conversations with each other. As perhaps the only person in the building with any interest in so doing, when the script was finished I had to test it by informing colleagues that I had written an AI program. When they typed the appropriate command at the prompt (on teletype printers I think rather than screens) they would be presented with two options — Psychology or Polite Conversation. By this time I had disappeared to my own console ready to don my Freudian or friendly hat. Not everyone guessed immediately what was going on and some polite conversations or analyses were able to develop — I was eventually quizzed by my boss who I suspect was not entirely unamused. Ten years later, it was the birth pangs of the Web and bulletin boards were already popular with techies and those with access to equipment at work or school. I set up a math group on one of the UK boards and set a programming puzzle that seemed of technical as well as philosophical interest — to write some code (in any language) whose output is the same as the code which drives it. I think someone solved it by using a print file command where the said file was suitably set up first — if I ever set this poser again I must be sure to exclude printing files. Thankfully the web came along and now one has to be truly original to be original. I love the way we all act as synapses and what used to take years can now happen in a day.

Sam Humbert comments:

"To write some code (in any language) whose output is the same as the code which drives it" is a well-known idea, at least nowadays. This is called a Quine, after the philosopher W. V. Quine.

Oct

12

To me the most significant lesson of recent international military undertakings has been how a country's taking action risks sacrificing what that country previously enjoyed in the power, reputation and deterrence of potential action.

For example, going back to the 1967 and 1973 wars, the Israeli military had the reputation of being unbeatable by its Arab neighbors. This gave Israel very valuable deterrent protection against its hostile, far more populous enemies.

But when Israel launched a major attack on Hezbollah in Lebanon and was unsuccessful in that Hezbollah was able to fight it to a draw, major damage was done to Israel's military reputation and deterrent power. Israel is now far more vulnerable to attack by hostile neighbors and by major terrorist organizations. With the benefit of hindsight, Israel should never have risked its reputation and deterrent power in a voluntary war unless it was virtually certain of prevailing and thus keeping its reputation for invulnerability and deterrence in effect.

Similarly, after the First Gulf War, the bombing campaign in Bosnia and the impressive early destruction of the Taliban in Afghanistan, the US had an awesome reputation of being the world's sole superpower, with virtually unlimited high tech military power several orders of magnitude above that of any other country.

But for the US to undertake a major invasion of Iraq that turns out unsuccessful, to become bogged down in a losing war against militarily unimpressive enemies, has done incalculable damage to the US's ability to cow hostile nations with its military potential. Again with the benefit of hindsight, the US should have thought long and hard about risking the unparalled military reputation and deterrent strength it enjoyed.

Now that the US's perceived military strength and ability to deter is far less, Iran can do what it wants in developing nuclear weapons and funding/arming Hezbollah, and even North Korea can feel pretty safe in its provocations. The degraded military reputation of the US also gives it far less ability to influence Russia and China to help with Iran and North Korea. And Russia can also feel free to strongarm our ally Georgia (the country, not the state) with little or no complaint from the US.

(I am not dealing here with the question, moral or libertarian, of whether the US should be attempting to deter or influence other countries. Only with the question that if it wants to, whether it has the power to do so.)

Finally, the relevance to investing of giving up the power of potential is, I believe, tenuous. It is true that when one moves from cash to a committed investment not easy to sell, one loses the potential to invest in other things or to remain in cash. But there is no reputation or deterrent value that one is giving up, since stocks and other investments are not capable of being threatened or deterred. (Except perhaps in rare cases where an extraordinarily rich investor like Icahn or Kirkorian is threatening to buy a massive amount of a company's stock if the company refuses to do what he wants.)

Prof. Marion Dreyfus replies:

A deterrent power that is never invoked, on the other hand, becomes a straw man, and ankle-biters will proceed to a series of provocations to test the level of tolerance of that so-called massive deterrent potential. Israel had been repeatedly provoked by thousands of Kassams and Katyushas against northern cities, and precisely how many thousands of incursions it can sustain is not an exact science. Nor is it in her interests to permit little gangrenous groups to pick off her soldiers and murder them at will.

This leaves out the concomitant scandalousness of the unpreparedness of the IDF. Both in terms of tank platoons and soldiers guarding the perimeter, there was a feebleness of deployment that stuns most of us familiar with the power of the IDF. A major contributor to the lack of overwhelming force and the triumph of the IDF, too, was the constant effort to save civilians, which is no way to win a war against soulless automata. had the Israelis conducted the war in the way most nations would and do, it would have won inside of a week.

Craig Cuyler replies:

These points could also be related directly to proper means of speculation, ballyhoo deflation and scientific method in trading. The US government has ignored almost every rule of proper speculation and here are just a few off the top of my head:

1. The US got itself into a war based on spurious correlations (the link between Bin Laden and Hussein)

2. Hindsight bias (Bush snr's previous Iraqi war in which the US came out relatively unscathed with its reputation intact)

3. Data mining (the Hunt for WMD's and the Yellow Cake uranium from Niger, both which didn't exist)

4. The doomsday scenario (pre-emptive attack on Iraq would prevent further attacks on US) - Iraq was never going to attack the US it didn't have the means,

5. Trading on tips and unsubstantiated rumours (the US being conned by Big Oil and others with their own agenda),

6. Trading with too much leverage and no risk management (how long can the taxpayer pay for this mess in Iraq, how many more innocent people on both sides must die before the stop loss is hit?).

As Dan says, the situation has weakened America's military position and standing in the global community and the direct beneficiaries are the Iranian Mullahs and psycho's like Kim Jong Ill who are now emboldened to develop their own nuclear arsenals. This is similar to when hedge funds like Amaranth get themselves into trouble and the market knows that it can press its advantage until the protagonist capitulates - this is what Iran, Jordan, Hezbollah, Taliban, North Korea and others will do. When an investor or a speculator puts on a trade for the above reasons there can be only one outcome - failure!

Stefan Jovanovich responds:

The 1973 war (what the Israelis call the "Yom Kippur War" and their opponents call the "Ramadan" or "October" War) was the worst crisis in Israeli military history. Within the first week the Egyptians crossed the Suez Canal and breached the Bar-Lev fortifications in what was probably the greatest feat of Moslem arms since the Turkish defense at Gallipoli. The Bar-Lev fortifications had cost $500 Million (in today's dollars roughly 1/3rd of the 2007 Israeli defense budget) but they were breached with water cannons, rubber rafts and hand-carried weapons and the battalion holding them was effectively wiped out. There are other details of the war that match the failure of the Bar-Lev line, but it is enough to note that, immediately after the war was over, a special commission headed by Chief Justice Shimon Agranat of the Israeli Supreme Court was appointed to investigate "why Israel had been caught by surprise and why so much had gone wrong during the war itself". The commission's report, completed in January 1975, was highly critical of the performance of the IDF on several levels, including intelligence gathering, discipline within the ranks, and the mobilization of reserves. Among the facts in the report was the disclosure that the IDF needed the emergency airlift of $1 billion of ammunition (in 1973 dollars) from the United States to avoid literally running out of bullets. To gain a proper sense of the scale of this potential disaster, it is useful to know that the entire cost of the war for the Israelis was $5 billion. (One of the bitter reflections that we Viet Nam veterans try to avoid considering is whether the 1975 Democratic Congress would failed to fund the reinforcement of the IDF as cavalierly as they refused to resupply the ARVN.) The Yom Kippur War ended the political future of Moshe Dayan. Ariel Sharon was lucky enough to have retired as commander of the Southern front 3 months before the war began. Had he remained in command, he, too, would have seen the end of his career as a figure in Israeli politics.

The tactical difficulties the IDF experienced against Hezbollah have a great deal in common with the mistakes of the Yom Kippur war. The Israelis badly underestimated the usefulness of anti-tank weapons against infantry (most of the IDF casualties were from blast and shrapnel, not bullet wounds) just as the IDF underestimated the lethality of Sagger missiles.

As for American bombing in Bosnia (sic) (the air strikes were in Serbia proper), the American after-action reports are almost sarcastic in their assessments. The Serbs, displaying their native criminal ingenuity, managed to shoot down an F-15 using cell phones and 1970s-era Soviet missiles. The USAF was unable to even "bounce the rubble" since most of the "targets" destroyed in Kosovo turned out to have been decoys. The U.S. Army had to wait a month to cross the Danube while the combat engineers (not under fire) rebuilt the bridges. When they finally made it across, they discovered (surprise, surprise) that their M1A1s were too heavy for the roads. The war ended General Wesley Walker's military career and began his political one.

Fortunately, both the IDF and the U.S. armed forces have learned from their mistakes and will continue to do so. The wars being fought in Iraq and Lebanon (yes, it is still going on) have taught both militaries that tactical intelligence can no longer sit even at the brigade level; it has to be down at battalion and even company level. Both militaries have also learned that they have to have the ability to jam enemy electronic signals not just in the air but at the street corner level. These are revolutions in military affairs comparable to the development of armor and automatic weapons.

To conclude  that "US's (and, I presume, Israel's) perceived military strength and ability to deter is far less" is to go against all the known facts of what those countries' enemies are actually doing. Both the Russians and Chinese are working as fast as they can to abolish conscription and reduce overall troop strengths. Both have effectively conceded to the Americans permanent air and space superiority by ending their next generation fighter programs. The field strength of Hezbollah, Al Qaeda, Taliban and the Baathists has been reduced to the level of banditry and local thuggery, and their internal documents speak of reduced levels of financial and military support and, in some cases, of outright despair. Their only hope is to win the battle of CNN.

I can go on, but what would be the point. That the New York Times and Washington Post and CNN remain unaware of what is actually going on in the Middle East and East Asia is hardly surprising, given the fact that their correspondents no longer spent any time in the field but leave that to their native stringers. That members of the list continue to retail the daily "everyone knows" historicisms of the "authoritative press" is disappointing.

Laurence Glazier replies:

More than 20 years ago, I remember reading media assessments that Israel was unlikely to survive more than a few years. I think this is still a good case to be contrarian. Other things being equal, Israel is and will even more so be one of the economic powerhouses of the present century.

There are — as ever — challenges.

Aumann may shine in game theory and bible code analysis but Buffett gets the nod in buy and hold.

J. Klein replies:

It was not only media assessment. 30 years ago I bought land in Israel, and all my friends advised against it, Israel couldnt last, too much risk, what a meshugge thing to do. It turned out to be a hit, by far.

Israel government has announced that it is planning a second wave of settlement erradication. The idea is to cut ourself free from our turbulent, violent, suicidal, no-good neighbors by a good fence. It is only expectable that Prof. Aumann, a believer, would argument against it, since we are giving up land aka Promised Real Estate.Nobel Prize does not make him a prophet, and less so in his hometown.

Sep

25

The Math Behind the Music (Cambridge University Press, 2006) by Leon Harkleroad, will be of interest to musicians, mathematicians and marketicians. In a form that is accessible to every layman, the author describes the elementary mathematical principles behind sounds, instruments, compositions and visual aspects of scores in just 135 pages with a nice section of references and an included CD that covers examples of music that used math. No background is required as even such simple lower-school concepts as the factorial are developed by counting.

The first chapter is about the connections, history, common abstract patterns, and the composers and compositions that used math. The second chapter is about the physical basis of harmony, pitch and timbre that make up music. Considerable attention is paid to the frequency relations of various harmonies, and it's a good refresher for those who don't remember off the top that a fourth comes from any note by raising its frequency by 4/3, a fifth by raising its frequency by 1/2 and an octave by doubling. Sine curves are introduced to encapsulate the frequency patterns of various notes produced at different pitches by different instruments. Overtones are explained simply as the ratios of higher frequencies that a note produces that don't block out the original frequencies and the relation between harmonies and overtones is shown.

The third chapter discusses instrument tuning systems consistent with all the overtones and frequency relations between the notes of a scale.

The fourth chapter is the most interesting in that it shows how themes and melodies can be varied with simple rules such as opposition, inversion, and transposition. The relation between these simple rules and group theory are examined, and various ways of notating and combining the rules are covered.

The fifth chapter is about bell music, which is merely a variation of permutation and combination theory.

The sixth chapter is about randomization in music, with many of the same methods used to construct music as we use for simple simulations in markets.

The seventh chapter is about an attempt by one student to find the common basis, the patterns of harmony that make up the most popular songs. The eighth chapter is about how scores of music can be developed from visual cues, with rules to go from visual to music.

The ninth and final chapter is about failed efforts to combine music and math, with particular reference to George Birkhoff's efforts to develop a complete theory of aesthetics by developing a scale of beauty based on the simplicity-to-complexity ratio of a composition.

I found myself thinking many times of the relations between music and markets as I read the book. The combinations of opposites and inversions (where the intervals above a note and played the same intervals below, and transpositions (where the same theme is repeated a given number of intervals up) happens every day in the markets. The notation that musicians have developed to grapple with these techniques, including the summary of horizontal and vertical movements in visual sightings that the composer Villa-Lobos used to construct symphonies that depict buildings in a city, seems like a very fruitful field to augment technical analysis of markets.

The book is full of anecdotes and charts and methods that will be right on the top of the page for market practitioners, and will spark many a fruitful extension by those who wish to take the pencil to paper, and systematize what they have been doing in markets or charting with the work of some great composers and mathematicians in this related field.

Laurence Glazier offers:

This sounds a fine book. Abstract shapes indeed can be used for thematic material, in my chess days I considered using the outline of pawn structures like black's in the Dragon Variation. My mentor uses the letters in his friends' names. Music is developed by changing patterns in various - ever-changing! - ways, whether transposition, inversion, speed-changing, and I would add to the list in the book the use of rotation, a technique Chris Sansom and I used in the Fractal Music software. All this (except presumably rotation) applies in trading. The issue is whether it is predictive for traders, and that is akin to trying to predict what a Bach would do, the patterns are especially evident once they have happened.

Sep

7

Thanks to a helpful hint from my colleague Vince Fulco I have recently become acquainted with an academic paper that I do not think I had seen previously, and would like to remark on:

Michael Stutzer: A Simple Nonparametric Approach to Derivative Security Valuation, Journal of Finance, Vol 51 #5, December 1996, pp1633-1652

As my friend Kris Falstaff often points out, the Black-Scholes framework for option valuation is based on an erroneous assumption, that stock price changes are lognormal. Of course alternative models can be and have been developed, such as those that incorporate jumps in prices and fluctuations in volatility, to get around this limitation. But then Kris could reply "that is not the real stock price process either."

A more radical approach is to make no assumptions about the distribution of stock price changes but just use the actual changes that have been observed in the past. This would amount to using a histogram of price changes instead of an analytical form for the distribution (for example the lognormal form). If the observation period is sufficiently long this should give an accurate representation of real life stock price changes. This can be called a 'nonparametric' approach or a 'historical' or 'empirical' approach to option valuation. ('nonparametric' in this context simply means "without assuming a distribution"). The Stutzer paper gives a simple procedure to implement this approach.

In brief there are three steps:

1. Using a large amount of historical price data, compute the empirical distribution of stock price changes over the time horizon T of interest (T= the maturity of the options we are trying to value). This gives a vector RH of all the possible price changes that have occurred over intervals of length T, and a vector PIHAT that assigns a probability to each. Since we have no reason to assume any one outcome is more likely than any other to occur in the future, all the entries in PIHAT should be the same, i.e. an equiprobable distribution. For example if we have 1000 different entries in RH, we should set PIHAT(i)= 1/1000 for i=1 to 1000.

2. We transform the empirical distribution found in (1) into a risk neutral distribution. Stutzer argues this should be done using the Kullback-Leibler Information Criterion. The vector of possible outcomes RH remains the same, but the probabilities PIHAT associated with these outcomes are replaced by a different set of probabilities PISTAR. The beauty of the Kullback-Leibler Criterion is that it gives an explicit, relatively simple way to compute PISTAR:

PISTAR(i) = \frac{exp[\gamma RH(i) / r^T}{\sum_j exp[\gamma RH(j) / r^T}

where \gamma is a constant given by another relatively simple expression, and r is the interest rate.

3. We can now compute the value of any option (or other European-style derivative) by taking the expectation of the payoff under the risk neutral distribution. For example to value a call option we would compute the expectation of Max[S-E,0] over all scenarios contained in the RH/PISTAR vectors.

It is a very interesting algorithm. The part that I am not completely convinced about is the idea that the Kullback-Leibler criterion is the correct one to use to find the risk neutral distribution; Stutzer has an explanation that makes it sound plausible, but somehow it was not completely persuasive (or rigorous) to me.

This is the best published paper on empirical option pricing in my opinion (although there are not many published), and it forms the basis for Emanuel Derman's Strike-Adjusted-Spread concept, that we can talk about next time.

Laurence Glazier comments:

This is very interesting and it would be good to see a worked example. It does rest upon an assumption that previous stock price movement is to some extent predictive of the future. Can we test if this is so? Also if Black-Scholes or similar is universally believed in by options traders does that not make it effectively true in a cultural context? I would be most interested in pricing theory to see an account made of the latent energy of an option, i.e. as the stock drifts slowly up, the option is gearing up, tensing to jump to the next level, and we want to identify this point so we can buy just beforehand. I am thinking here of a spiral motion up from a kind of Argand plane — when a full revolution is made the real option price moves up.

I think the weakness of Black-Scholes is the use of Vega, which is like the god of the gaps. It is a truly useful piece of social engineering, however, which enables the industry to run.

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