Friday, November 04, 2016

Successful Trading and the Art of Asking Great Questions

The most impressive traders I know ask really good questions.  The least impressive traders I know don't ask questions.

This morning I've been up for a while and having quite a few online conversations.  One of the major topics has been the recent rise in VIX, put/call ratios, and options skew in the index option market.  Does that mean that bearishness is overdone?  Does that mean that smart money is pricing in a surprise election outcome?  In the face of such sentiment, how can one best position one's risk-taking before and after election results?

Out of these questions, I quickly updated a model of options skew that looked not only at the absolute level of skew, but also rates of change and skew volatility.  Some very interesting patterns emerged, suggesting that a high level of downside hedging has been associated with subnormal near-term returns, but superior intermediate-to-longer term returns.  In other words, we see hedging when the environment really is dicey, but it is those dicey environments that ultimately draw in value participants and lead to favorable longer run returns.

Good questions don't simply lead to good answers.  As any scientist knows, good questions lead to good research and investigation.  Research tells us that creative, productive people are great at problem finding.  They ask *meaningful* questions.  If we merely avoid or run from problems, we never ask the tough questions that yield important insights.

Further Reading:  What We Learn From Options Skew