Count me among those who maintain that buying high and selling low is unlikely to be a successful trading strategy. But if enough people believe otherwise, they can wreak a bit of havoc on the rest of us before they themselves go belly up.
There is a class of traders who will buy high and sell low as a hedging strategy: option writers. Suppose that you rode the rise in oil prices by writing put options on oil. When oil was at $90, you collected a fee for giving somebody the option to sell at $85, which would only be worth something if the price went back down. When oil got to $100, that option looked pretty worthless.
When you write an option like that, if you want to stay solvent, as prices decline you have to start to sell oil short in order to hedge your position against further declines. Suppose that when the price was $110, you wrote a put option with a strike price of $102. While the price is $110, you do nothing. But as the price falls to $105 and below, you short oil in order to avoid having a huge risk exposure.
By the way, note that the folks who were in the business of writing call options on oil had to buy oil futures any time the price went up.
Any time there is unstable market behavior, I always suspect option writers. “Portfolio insurance” in 1987 is one example. Credit default swaps are another. I think that is all too easy for option writers to adopt strategies that seem to make sense individually but which collectively cannot be implemented when the need arises.
READER COMMENTS
Biagio
May 11 2011 at 2:29pm
I think what you say is correct, but it does not go against the passage quoted. James Hamilton talks about an asset (not a derivative) in which, crudely speaking, things look good/bad to a buyer/seller if the price goes up/down. When you start mentioning puts, of course everything needs to be seen as a mirror image, but everything stays the same. To be clearer you cannot necessarily compare the low/high of an asset with a low/high of the underlying of a derivative.
Also, it is not true (using the numbers from your example) that when the price is at 110 you do nothing. If you are someone who hedges himself you hedge yourself all the time (particularly in a simple example like the one you mentioned), from the beginning to the end of the contract (in the case the oil put). It is a pillar of risk neutral valuation.
It is exactly because the basis of risk neutral valuation is a complete synthetic representation of the derivative through a buying/selling of the underlying that things go wrong when this representation fails. No one stops you from writing an option on a stock for a notional far greater than the market capitalization of the company issuing that stock: however when you will try to hedge yourself you will not be able to do so or you will seriously distort the market.
E
May 11 2011 at 3:27pm
Options are zero sum. The net delta across the options world should always be zero.
John
May 11 2011 at 3:34pm
Yes, the seller of the put may short the underlying asset and then buy it back at a higher price to remove the hedge on the put position. I don’t think that’s a large portion of the market volume as it’s cheaper and less risky to hedge the put with a call.
I’m not sure what James is really saying as I don’t think anyone, much less a bunch of people, believes buying high and selling low is a winning strategy. I suspect what he’s talking about are the momentum traders.
While these traders may impact the market I suspect the larger distortions are to be found in monetary policies designed to provide liquidity to financial markets and some of the underlying margin policies. The combination of the two have a much larger downward cascade of prices than the impact of momentum traders (which are enabled by the other two factors).
I think the pure momentum trade impact is that of sector rotation rather than general market bubbles.
some commenter guy
May 11 2011 at 11:25pm
I think one day we may discover a similar kind of instability in the (massive) market for interest rate swaps. What exactly would happen to this market if we suddenly had interest rates move as violently as they did from 1979-1983?
The good news is, I don’t think such a problem will arise until the US experiences its debt crisis. And that, in turn, probably won’t happen until after the European sovereign debt crisis unfolds. And after that happens, the feds will own all the banks anyway.
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