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Your analysis of LTCM is incorrect. They were not OTM option sellers. They
were dynamic hedgers and very little unhedged option trading was involved.
Delta hedging doesn't work if prices are not continuous...add the leverage and
that is what killed them. Think of a covered call write with huge leverage.
Image what happens when the stock gaps down and the volatility goes up. You end
up losing money on both sides of the position. The gap ... non continuous
pricing .... means you can't adjust your hedges. Modest moves can be
devastating because of the size of the positions.
Lawrence Chan wrote:
> the whole story was detailed in a book.
> will find the title and post it.
>
> they basically sell some very very out strike options on some
> exotic derivatives and bonds at a dirty cheap price, but
> in HUGE SIZE all the time.
>
> so when the mkt start going against them FAST,
> which is the key problem for option sellers, they cannot do
> a thing but just watch themself sink.
>
> plus, they thought (like all option traders) the first move
> against them is normal ... like 99% of the other trades they did,
> the mkt SHOULD return to the original level ...
>
> Thus the mkt condition did not change against them, its just that
> they failed to calculate the option price properly - using chaotic
> assumption, instead of the stupid B.S. model :)
>
> With chaotic model, you do not sell very very out strikes, because
> their prices instead of going very cheap, they can go inifinite in
> many cases :)
>
> The moral is to LONG these cheap options at a rediculously cheap
> price from time to time as lottery tickets .. who knows what will
> happen :)
>
> I do know a friend who use part of his job salary to buy dirty cheap
> options on OEX (before) and sp future options (now) every month.
> He is toasted 90% of the time, but his net gain is in the millions mark :)
> like last nov, dec, and the jan this year - he made back all the bets
> he made in the past 2 years plus more.
>
> back to LTCM, as they are a fund, they are forced to perform,
> thus, lottery type of trading cannot be used as the clients will go mad
> on them ...
>
> -Lawrence Chan
>
> ----- Original Message -----
> From: M. Simms <prosys@xxxxxxxxxxxxxxxx>
> To: Omega-List <omega-list@xxxxxxxxxx>
> Sent: Monday, February 14, 2000 9:59 AM
> Subject: Trillion Dollar Bet - anyone impressed ?
>
> > Last week's airing on PBS of the LTCM debacle was interesting in that
> very,
> > very little details of the fund's techniques were unveiled. In fact, it
> was
> > kind of stupid when it was mentioned that LTCM dropped $500 million in one
> > day.....yet gave no clue as to how that was actually accomplished. It was
> > probably a trading "record".
> >
> > Obviously these guys were leveraged with options and/or futures in such a
> > way that long and short "bets" were supposed to offset each
> other......based
> > on prior relationships.....
> >
> > Moral of the story: backtesting alone won't hack it in the long run. When
> > economic or market conditions change drastically, make sure your system
> > either adjusts properly or STOPS TRADING.
> >
> >
> >
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