Jamesian Philosophy Refreshed

The above graph is a visual representation of the Black-Scholes model. Or Black-Scholes- Merton if you want credit shared equitably and "you're not into the whole brevity thing," Mr Lebowski. As you can see, there are three axes. The x axis (the width of the box) is the price of the underlying asset, the stock price, treating the strike price in the center as 1. The y axis (the height of the box) is the volatility of that option. The z axis (the depth of the box) is the time to maturity [and either exercise or expiration].   As you can see, the plane of various shades of blue (the darker the blue, the higher) has a sharp crease at the front/center/bottom of the box, where the sharp difference between winners and losers on the lottery’s drawing date is indicated. We should also mention that the volatility that goes into the calculations as we’ve described them above is historical volatility. One of the assumptions of the BSM model is constant volatilit...

We'll resume our discussion of stock options from where we were here. The above photographed felon will come into our discussion soon enough. Options can be part of broader strategies that limit exposure in either direction. You can combine puts and calls to create a “collar” around the market price of the underlying stock, limiting both your own profit and your own risk. The word “straddle” has connotations similar to “collar,” suggesting that options allow the straddler to be on both sides of the same underlying asset at the same time. Yet “straddle” has a more aggressive sound to it. As it happens, Bernie Madoff used to tell prospective clients that he was following an options-based straddle strategy.   Of course, he wasn’t following any strategy, but he needed to sell a story, and that was it.   Such a straddle strategy, by the way, can work when carried out legitimately. It can do roughly what Madoff claimed that he was using it to do – produce a slow-but-...

  We can reasonably hypothesize that “Mr. Market” is rational, and knows a lot of stuff, because there are a lot of people out there looking to make a buck off of any slip-up, looking to get an edge, to learn something he doesn’t know, and to trade on that basis. Further, all their trades on the basis of what they learn in that effort make him smarter. They contribute to determining prices, so that an “edge” that still worked a month ago may be outdated now, as Mr. Market has learned to factor it in. And that is why (especially according to advocates of the ECMH) stock prices move in a random walk. It is random to any observer not as smart as Mr. Market himself. Any given neuron will presumably see the thoughts of the whole of the brain as a random result of who-knows-what. There is nothing mystical about this – the confused neuron, in its own trading, helps to bring the situation about. Now, when I’m asked whether I believe in ECMH, I generally reply, “yes and no.” It ...

Aside from the considerations we discussed last week, there is this to remember about stock performance, the performance of a stock as an investment is not (entirely) a matter of whether it rises or falls in price. A stock also entitles its holder to a portion of whatever dividends the issuing company may declare. Suppose, then, that we do the arithmetical magic to factor in the dividend stream as if it were being paid out day by day, and we included that along with the stock price move as the performance of XYZ. Once we do this, we’ll want to be sure that we’re matching the stock price against a broad market benchmark that also includes dividends as part of performance. Fortunately, these are readily available. The S&P Index, for example, comes in three variants: one that considers solely the price of component stocks; one that factors in dividends (the “total return” index); and a third that subtracts the tax on those dividends (“net return.”) We might make discussi...

  Last week our discussion took us as far as to a description of the normal or Bell curve. See a depiction above. The numbers at the bottom of the graph refer to “standard deviations” from the norm. We were discussing specifically mileage errors on maps. One standard deviation from the mean (the area between -1 and +1 on our graph above) accounts for roughly 68 percent of all the maps in our hypothetical database. Two standard deviations from the mean (the area between -2 and +2) account for roughly 95 percent of the maps. Three standard deviations account for 99 percent. A normal curve for a phenomenon is taken as evidence of randomness. If there were some reason why the mapmakers of 17 th century England were inclined to make a particular error that reason would show up as some non-normality in this chart. Perhaps the roads between these two places were especially good by the standard of the day, and the ease of travel created a general impression that the cities were...

I said in an entry last week that a downgrade from Morgan Stanley was a reasonable candidate for the cause of a downward stock price move, as we intuitively understand the idea of cause. But proving this would be a trickier matter. It would require showing that there was nothing else happening that evening or morning that may also have had consequences for that demand. Or, if there were other things happening, if would require some measure by which we could distinguish this causation candidate as more potent that the others. Even if it is a very general rule that similar announcement proceeds stock price fall, other explanations are possible. After all, since we’re assuming that Morgan Stanley’s analyst was working from publicly available information, we could hypothesize that a lot of traders and in-house buy-side analysts reached the same conclusion at the same time Joe Smith did and would have reached it even if Joe Smith had had nothing to say, or had through some analy...

-------------------------   We could kick off a new line of thought by asking a qualitative question: why did the stock price of XYZ Inc. fall yesterday? When we ask a “why” question of that sort, we are making a presumption: that facts in the world – in this case, facts in a peculiar but well-defined social institution – have causes, and these causes are susceptible to rational explanation. In this case, we might say (recalling what a high school teacher told us about economics) that the value of XYZ shares fell in order to preserve the equality of supply and demand. But that doesn’t really get us far. The supply of stocks is relatively inelastic. New issuances of stock, especially new issuances of those stocks listed in any of the leading indexes, are rare events, and we can leave them aside for now.   Let us take it as a given that a constant amount of   XYZ continues to circulate. Then we’ll be especially interested in demand. What does i...