The Half Baked Lunatic

Back in 1973, two mathematicians named Fischer Black and Myron Scholes wrote a paper entitled "The Pricing of Options and Corporate Liabilities".  This became known as the “Black-Scholes option pricing model”, which earned them a coveted Nobel Prize in economics in 1997 (technically, Myron Scholes shared the prize with Robert Merton, another collaborator, since Fischer Black had passed away by that time).

The Black-Scholes option model serves as the benchmark for setting the price of a common stock option. All you need to know is the stock price, the strike price of the option, the time left to expiration, the current interest rate, and this tricky little thing called the volatility of the stock.

Ahhh, the volatility. There’s the rub. The volatility of a stock is calculated using an iterative process called a “cumulative normalized distribution function”. Basically, it looks at the variations of a stock’s up and down movement over a certain time period and offers up a percentage of the average movement. The volatility is an absolute measurement, which is different from a stock’s “beta” – the beta is a ratio of that particular stocks’ volatility as compared to the rest of the market, which is actually much easier to measure.

In my definition of volatility, I said that it relies on the variation of a stock price over a certain period of time. But what period of time should you use? One week? A month? Three months? Six months? A year? Maybe two years? The time period that you use can make a huge difference in the value of the option, but there’s no general recommendation for what period to use.

All of the other factors (stock price, strike price, time to expiration, etc.) are quantifiable values that can be specifically defined. The volatility, however, requires a bit of artistic interpretation.  If the stock was highly volatile nine months ago, but is more stable now, then measuring the historic volatility over the last six months is probably a good choice. Or not.

The chart below shows the stock price for Intermune (Symbol: ITMN), a small biotech company. In early March of 2010, an FDA review panel said that they would recommend approval for Intermune’s new drug and the price soared from around $15 per share up to the high $40’s. The FDA chose to ignore the recommendation of the review panel, and they decided not to grant approval in the first week of May, asking instead for additional information, which drove the price back down to under $10 per share:

Below the stock chart, you see another graph with three lines – the orange line is the volatility over the previous 30 days (one month) and the blue line is the volatility over the previous 60 days (two months). Anyone looking at the stock chart would agree that the stock was highly volatile throughout March, April, and May – but the “30 Day” measurement (orange line) shows that the volatility dropped down below 50% during most of April, as there wasn’t that big of a movement in the stock price over the 30 day window from about April 5 through the end of the month.

In contrast, the 60 day line (in blue) shows a more representative picture, as the period of high volatility lasted for almost exactly 60 days.

Note that the scale of the bottom graph tops out at 100%, which is normally considered a “high” volatility ... but both lines go up well over 100%, with the 30 day (orange line) volatility hitting a whopping 400% or so during May!

The red line shows the most interesting aspect of the Black-Scholes model: the “Implied Volatility”. This is a fascinating subject, and discovering all the nuances of the Implied Volatility has been a passion of mine for quite a few years now. Look at it this way: let’s say the Black-Scholes model says that an option should be worth $2.25 per contract, using a historic volatility of .55 for example (or 55%), but the option is really selling for $4.00 per contract. You can plug all the numbers into the formula backwards, and instead of solving for the price, you start with the price and solve for the volatility.

Suddenly you find that although the “historic volatility” of the stock is 55%, the current price suggests that the “implied volatility” is 90%. This means that the market thinks that the volatility in the future will be higher than it has been in the past. The market price is “implying” a higher volatility.

Again, there is no “time period” for calculating the Implied Volatility – but unlike using the historic volatility, you have an advantage. You can use different forward looking expiration dates to see when the market thinks the volatility will increase. So if you have options expiring in three weeks and again in seven weeks, you can see if the Implied Volatility is different between the two – which can give you an idea of the time period of expected increase in volatility.

In the above chart, the red line shows the implied volatility of the “near term” options. Note that leading up to the first week in March, the price of the stock is stable and the historic volatility is relatively low – but the price of the options went up steadily throughout the entire month of February. This is because the market anticipated the upcoming announcement – but no one was sure if the news was going to be good or bad. Again, in the month of April, as the 30 day historic volatility line went down, the implied volatility climbed back up as investors were looking forward to the final ‘yeah or nay’ vote from the FDA.

Is this just an academic exercise? Certainly not!  If a small pharmaceutical company has an upcoming decision by the FDA announcing whether their drug will be approved or not, or a small defense contractor is waiting for word of a large military order that will either make or break the company, then the implied volatility will almost always go up. Sometimes waaaaaaaay up. There is no other “traditional” technical indicator that can give you a heads up as to an upcoming move in a company’s stock price when it is up against a “binary event” like this.

So what is the “dirty little secret” of the Black-Scholes formula? Well, I’m not going to tell you.

Ok, I’ll spill the beans: the volatility and the implied volatility will almost always move in exact opposite directions from the calculations around the “Binary Event” date.  The Black-Scholes pricing model completely falls apart in this situation ... before the event, the historic volatility is low, and the Black-Scholes analysis (using the historic volatility) will say that that the option should be priced low – but as the market is anticipating a large movement in the price of the underlying security, the price of the option goes up (as measured by the “implied volatility”). Conversely, after there is a big change in the stock price and the historic volatility is very high, which would normally indicate a high price for the option going forward, the option price is low because the market does not foresee another big change in the near future.

What’s the bottom line?  What can an investor do with this information?

It’s a bit tricky. An astute options investor can monitor the Implied Volatility of all the stocks in the market and get a very good indication when a particular stock is going to have a big move in the near future – but there is no indication what direction the move will be. In a highly liquid market like we have with U.S. securities, the stock price itself would move if there was a reliable consensus of whether the news was going to be good or bad.

Buying or shorting the stock itself is not a viable strategy, since you don’t know what direction the stock will move and the odds are it will move quite far, so potential losses may be substantial.

In a “perfect market” the analysts following the company would project the potential high and low price of the stock after the news is announced (depending on whether the news was good or bad), and the stock would float almost perfectly in the middle of that range until the news was announced ... and the price of the “at the money” options would be one half of the expected move; meaning that the cost of an option straddle is expected to be the same as the anticipated movement of the stock. So if the stock was $50 per share, and the analysts expect the stock to move to either $35 or $65 (a $15 move in either direction) after the news is announced, the “at the money” options would most likely be priced at around $7.50 each for both calls and puts. 

This makes it difficult to use standard option strategies in this situation. Buying or selling straddles, covered calls/puts, or traditional spreads will almost always be unprofitable.

However, there are some multi-leg option strategies that can capitalize on the movement in one direction and minimize losses in the other direction. These trades are very complicated, and take a deep understanding of option dynamics – but they can be profitable if properly executed. You can also look at more obscure data like the “Volatility Smile”, the volume of calls vs. puts, or the ratio of ‘in the money’ vs. ‘out of the money’ option volume to try to glean some indication of what direction the other option traders think the stock will move.

The Black-Scholes pricing model is an amazing benchmark, used all over the world – but tread carefully if you find a situation where the historic volatility of a stock is fairly steady, but the option price (i.e., Implied Volatility) is rising dramatically. You can get in over your head quite easily.

For the past billion years or so, every animal on Planet Earth has been in danger of being eaten by some other animal at one time or another.

Humans aren’t immune from the risk, of course; just because we’re at the top of the food chain doesn’t mean we wouldn’t be a tasty treat to something else. A hiker was eaten by a bear in Yellowstone park just last week, and a few times a year we hear about sharks that feed on an unlucky swimmer.

So I get a little perturbed by folks who tell me I shouldn’t eat meat because it’s unethical, or because we’re “exploiting” animals for our personal gain. Frankly, if every animal on the planet stopped eating other animals, all species would die out. The “Circle of Life” would come to a complete halt.

Someone asked me if I’m a vegetarian and I said, “No, but I mostly eat vegetarian animals!”

Granted, in our modern society, homo sapiens (especially the ones living on the North American continent) should cut back on meat consumption. But from a health standpoint, completely eliminating meat from our diet is going too far in the other direction.  We are omnivores and always have been, and we require a balanced diet. Unfortunately, some people balance their diet about as well as they balance their checkbooks and they end up overweight AND broke!

Even though I’m certainly not a vegetarian, I do have many issues with our “factory farmed” meat production. Not just because it might be considered “cruel” to animals, but because we are getting increasingly isolated from our food supply.  In the past 100 years, we’ve become the very first humans in history where the majority of the population doesn’t know where our food comes from, or how it’s grown and processed. As long as the grocery store is fully stocked and the local restaurant can serve a hot dinner plate in a timely fashion, we’re happy.  We don’t want to think about where it comes from – and if we watch a video of a butcher at work, it’s considered “gross” for some reason. Why is that?  For thousands of years, More...

I’m really tired of seeing these news stories EVERY SINGLE WEEK about some kid (usually under age ten) who gets their hands on a gun and accidentally shoots themselves, a parent, sibling, or their best friend.

It’s not so much that I’m against guns; but I’m certainly against the American attitude towards guns.

Everyone is so concerned about their “right” to own a gun. But with rights come responsibility.  The question shouldn’t be “do I have the right to own a gun?” – the question we should ask is “am I willing to bear the responsibility of owning a gun?”

Pro-gun advocates often invoke references to Switzerland as a country where gun ownership is high and crime is low.  I lived in Switzerland for a year and just recently moved back to the USA. In Switzerland, every adult male must serve in the armed forces for at least two years, and those that have received combat training are considered “reservists” – and as such, they are required by law to keep their military issued service arms at home in case of an attack by a foreign country.

The difference is the Swiss attitude towards the firearms.  Gun ownership is for the protection of the country; it’s not for personal protection, not an item that is brought out and shown off to all your friends, not something that is brought along to the bank or grocery store, not something that you can buy and sell at a flea market or local shop, and certainly not something that is left lying around for kids to pick up and play with.  It is not a “right” to own a gun in Switzerland, it is a responsibility, which they take very seriously.

The Second Amendment to the US constitution states:

A well regulated Militia, being necessary to the security of a free State, the right of the people to keep and bear Arms, shall not be infringed.

I know the issue has been bashed to death by the courts, and everyone has very strong opinions on More...

Everyone knows that our national debt is completely out of control. But there’s an important issue that the press seems to be ignoring: the potentially devastating effect of rising interest rates.

The Federal Reserve is responsible for implementing our fiscal policy, but the Fed can not “set” interest rates – the overall market does that, based on supply and demand.  However, the Fed can influence rates by increasing or restricting money supply.  At the moment, just like in Louisiana and Mississippi, the floodgates are wide open. The bond market is awash in “virtually free” money, which is artificially keeping interest rates at historic lows.

But here’s the crux of the issue: with the floodgates open, the reservoir will eventually run dry – and the expectation is that interest rates will then rise. What happens to our federal budget when rates go up?  It could get really ugly really quickly.

Here’s why:

If you look at the chart in my earlier post, Trying to Make Sense of the Federal Budget, (the second chart, with the Social Security and Medicare numbers removed), you will see that interest payments on the federal debt clocked in at $218 billion in 2010, or 11% of our federal budget:

The weighted average interest rate of all the US debt currently runs about 2.07%.  Shorter term debt has a lower interest rate – less than .25% – and longer term debt has a higher interest rate – approaching 4.375%. When longer term debt is more expensive than short term debt, we have what is referred to as More...

It’s only been a few days since Osama Bin Laden was killed, and I can’t even count the number of news articles, opinion pieces, interviews, historical retrospectives, biographies, rants, and random comments I’ve read.

Most intriguing to me is the question of whether or not we should be celebrating someone’s death.  I’ve read a couple of interesting postings specifically on this subject, but it brings up some larger questions about humanity.

I’ve always considered the human race to be one big organism. Each individual person is like a cell in the human body, with their own specific job in life. But the overall total is what makes up the “body” of humanity. Some people do the majority of our thinking, some people do the majority of “manual labor”. Some people make it their life’s work to heal others, some provide food, and – just like the cells in our body – some handle the unpleasant tasks like hygiene and waste disposal.

And some people are like cancer. They grow up with the specific intent of killing others.

Some of these cancers are so insidious that they actually threaten the existence of all of humanity.

Our cells do fight back when threatened, and if they can’t handle the attack on their own, the heroes of our our body – the white blood cells, for example – come to the rescue. But sometimes, even more drastic measures are required.

If a patient has to undergo surgery to remove a cancerous tumor, the surgeon needs to cut out a little more around the tumor – removing some healthy cells in the process.  Consider that to be the equivalent to “collateral damage” in war (see my previous posting, Wrestling the Anaconda, for a humorous view of the “margins” that a surgeon needs to remove from around dead tissue during surgery ...)

Ok, it’s not a perfect analogy, but you get the idea.

The removal of Osama Bin Laden from the human collection was an extremely precise, laser accurate surgery – with very little collateral damage.  But 1) we left a lot of dead on the road to get to him and 2) he managed to infect others with More...

Pop quiz: What percent of our federal budget goes to the military? 

If you look at the “official” budget numbers, the White House reports that Defense spending takes up just over 19% of our budget.

Here is what our government spent in 2010, as reported by the Office of Management and Budget and the Department of the Treasury:

At first glance, this looks like a reasonably balanced chart, without any single slice of the pie taking up too much of the available dough (the pun was intended, although the joke was – admittedly – kind of crusty).

However, there’s been an unfortunate trend which started sometime around the Reagan era, where they try to “de-emphasize” the amount we spend on Defense by including More...

The height of the “dot com” boom was a pretty crazy time for investors; venture capitalists were investing huge sums of cash with any entrepreneur who could type the word “internet” without using a spell checker. People made some really BAD investments and only a few of the startups from that period are still operating today.

But there’s one deal that really takes the cake. This acquisition was so absurd in its reasoning and so insidious in scale that I’m surprised the story hasn’t been made into a Hollywood feature film.

Let’s back up a few years, to 1996. This was the year that yours truly joined a small internet startup called VXtreme, an early pioneer in streaming video on the web. VXtreme had actually developed a viable technology and we created what was arguably the best streaming video platform (codecs, encoder, player, server) in the world at the time.

Remember that in 1996, people were connected to the internet with 28.8Kbps modems – or if you could afford it, you might have one of the spanking new 56K modems.  Whoo-Hooo! Blazing fast internet it was, indeed. Delivering real time streaming video over such a connection was problematic at best – but it was SO exciting to see a media player embedded in a web page, rendering real time video with a resolution of 160x120 pixels at a whopping 15 frames per second refresh rate! We were truly on the bleeding edge.

In just over ten months, we built the company, produced the product, engaged a bunch of high profile customers, and sold the whole thing to Microsoft for about $74 Million (and to set the record straight, I was not one of the founders or shareholders – just a “late hire” marketing manager, with options that were only worth about 1/10th of 1% of the company).

It was a fair valuation for VXtreme.  Our technology was merged in with the “NetShow” product that Microsoft had been struggling with, and the platform was eventually renamed “Windows Media”. Even today, the Windows Media Player, Windows Media Audio/Windows Media Video file formats, Silverlight, and the More...

No one has ever said that amusement parks are a good deal ... in fact, they are universally considered to be total rip offs.

But after spending five days in Orlando with my kids, I think that the Disney Corporation has just one goal: they are trying to perfect the art of shifting any remaining cash balance from my bank account to theirs.

Mid-January should be a good time of the year to visit Disney World, I thought. This should be the “slow” season, shouldn’t it? Even though it was a holiday last weekend (Martin Luther King Day), I didn’t think the crowds would be all that bad.  On top of the holiday on Monday, my kids had two extra days off school for “teacher/staff development and training”, so we had Saturday through Wednesday – five very precious vacation days.

Unfortunately, it was so miserably crowded on Saturday (Magic Kingdom) and Sunday (Hollywood Studios) that it really was not much fun at all for the kids - much less the parents.

Then on Monday, it rained – hard – which at least thinned out the crowds somewhat. Luckily, that was the day we had selected for Animal Kingdom, which is probably the only Disney park that you can do in the rain (but many of the rides and activities were closed for at least half the day). On Tuesday we went to Epcot – the best park of the bunch, in our opinion. But even then we spent far too much time in lines to be worthwhile. It was very frustrating.

Disney World has this new scheme called the “Fast Pass” ticket. Here’s how it works: instead of waiting in line for a ride, you get More...

I’ve never celebrated Christmas.  Ever. 

When I was young, it never really crossed our minds – we weren’t Christian so it just wasn’t something our family did. I’ve never once had a Christmas tree in my house.

As I got older and started working in a professional career, I would usually go in to work on Christmas day – just because I objected to being told that I HAD to take a day off for some religion that I didn’t care one whit about. Usually, I wasn’t the only one there.

Except for a couple of “mandatory” gift exchanges at work, which were more office politics than anything, I’ve never given anyone a Christmas present.

And now that I have kids of my own, we all agree that it would be hypocritical to subject them to this custom just because of the social pressures of our society (which have unfortunately gotten worse over the years). 

I also get annoyed at the “celebration envy” that many non-Christians fall into. Hanukah is a minor Jewish holiday which no one outside of the Jewish faith would have ever heard of if it weren’t for the questions of “so what DO you celebrate?” – the idea of a “Hanukah bush” is an embarrassing distortion and any self-respecting Jew wouldn’t dream of putting one in their house. And what’s up with all these Winter Solstice parties? More...

The following article was written under invitation from the CommonGroundGroup, a website put together by some members of the Baha’i faith, for discussion of the common areas of agreement between science and religion. They seek to include alternative views and promote open discussion on topics of science, religion, and philosophy. I appreciate the invitation to contribute an article which is diametrically opposed to most of their normal postings.

I love evolution.

Just as biological evolution creates new species, information and knowledge and technologies also evolve – and in a very similar manner. Take the microprocessor that is running the computer on which I’m writing this article, for example. The electronic microprocessor isn’t the brainchild of a single brilliant engineer who just created it one day, without any prior information or knowledge. All modern processors are evolutionary offshoots of the Intel 4004, introduced in 1971. It was a huge breakthrough, but that milestone could never have come about without the invention of the transistor and the many simpler integrated circuits before it; and the core processing logic was built upon the mechanical and vacuum tube computers which evolved over the fifty years before that. None of these would have been possible without a working knowledge of electricity, magnetism, chemistry, and physics – the secrets of which have been slowly uncovered, bit by bit, for hundreds (thousands!) of years.

Evolution tends to go in fits and starts, especially in the early stages. There are the agonizingly slow changes that take millennia – the spinoff of one species to another for example, or the adaptation to environmental changes that all early life went through as the Earth cooled; for almost half of the 3.5 billion years that life has existed on Earth, there was nothing more complex than single cell organisms.

But then, occasionally, some big event comes around More...

My family loves Halloween. It’s our favorite holiday of the year – we get to decorate the house, wear costumes, go to parties ... and eat candy.

Lots and lots and lots and lots of candy.

In a society of bulging waistlines and bad eating habits in general, I really wish we could go just a little easier on the candy at Halloween.

I mean, what’s wrong with giving out only one small morsel to each trick-or-treater that comes by, instead of big handfuls?  What’s wrong with running out at a reasonable hour and saying “sorry, we don’t have any more” instead of buying so much that you’re stuck with pounds of leftovers?  What’s wrong with giving out something healthy, instead of candy, or a “trick” like some families used to do when I was a kid? (the idea used to be that you’d give out a trick … OR a treat.)

Sure, it’s just one day a year – but we have more candy sitting on our counter than I’d normally let my kids eat in an entire year.  Seriously. Maybe two years.

I tried to be reasonable.  I tried to get a small amount of candy, and supplement our offerings with little bags of pretzels. But my own family rebelled.  They turned on me. They ridiculed me More...

Newsflash: The cost of healthcare in America has been out of control for many years and we really need to do something about it!

Ok, so this isn’t news. And we already have the all-new healthcare reform legislation which fixes all our problems, right?

Unfortunately, this new law – officially called the “Patient Protection and Affordable Care Act” (PPACA) but more affectionately referred to as “Obamacare” – has some problems, and now a few people are lobbying to ditch this plan so they can come up with something different.

Part of the problem with baking up a new healthcare plan is that there are so many fingers in the pie, all with vested interests – you have the healthcare insurance companies, malpractice insurance companies, pharmaceutical companies, hospital owners, nurses unions, lobbyists, medical licensing boards, government agencies (FDA, HHS, CDC, VA, CMS, etc), the politicians (who love to shoot down whatever their opponents propose, no matter what it is) ... and let’s not forget the doctors and the patients themselves.  It really is fundamentally IMPOSSIBLE to implement any reform that won’t upset someone in the chain. It’s a political nightmare, and everyone knows it – but something has to be done. More...

Our container with all our belongings arrived two weeks ago, and we're almost finished unpacking. It’s nice to finally be getting settled in to our house.  Last night, we got started on the last big part of the process that needs to be tackled: The Books.

I've never really considered myself to be an avid reader, to me it's just a part of life.  It's like saying you're an avid breather.  Yes, I like breathing and I manage to do it on a regular basis, even with everything else going on in my life. That's how I've always felt about reading books.

But as I'm unpacking my library, I'm a bit overwhelmed by all the boxes and by trying to decide where to put all the books. And this is after doing a massive weeding out of my collection when we left Bellevue five years ago – I probably got rid of more than two thirds of my books at that time, only keeping the ones I really like or have specific sentimental value, or ones I might want to read again or refer to in the future.

I just did quick count of the books I unpacked last night, and I've read about 300 of them. So how many books have read in total?  Let's assume I've read two books a month since I was 10.  That would be 37 (years) times 12 (months in a year) times two (books per month), equals 888 books. I'm not really sure if this estimate is high or low. And if it’s about right, More...

In years past, when you purchased a VCR or a DVD player, it would come with a video cable so that you could go home, connect your new player to your TV, and immediately start watching.  It was usually a cheap combination audio/video cable – not very sturdy, but it would get the job done.

If you purchase a new Blu-Ray player today, however, you will find that not a single cable is to be found in the box. A high tech Blu-Ray player should really should at least come with an HDMI cable (High Definition Multi-media Interface, the preferred method of connecting any HD video source to a digital television).

 A decent quality cable costs less than fifty cents to make. Are the manufacturers just getting cheap?  Trying to cut corners?

Nope.  They’ve stopped including cables because More...

I’ve been back in the USA for two weeks now, and I’m still adjusting to a few things.

For the past year, my family has lived in Switzerland – and the whole time we complained bitterly about the high cost of food there.  Buying groceries to eat at home is expensive enough – but going out to a restaurant?  It’s completely outrageous.

The hot lunch program at our kid’s elementary school is a great example of food prices in Switzerland.  The “normal” school lunch was $10 – or you could get a “small lunch” without side dish or dessert for $7.50 (but it did come with a drink).  The third option was a plain hot dog in a bun for $5.50 (no drink included).

To put this in perspective: if we bought More...