Friday, September 18, 2015

Interview with Euan Sinclair

I have been a big fan of options trader and author Euan Sinclair for a long time. I have cited his highly readable and influential book Option Trading in my own work, and it is always within easy reach from my desk. His more recent book Volatility Trading is another must-read. I ran into him at the Chicago Trading Show a few months ago where he was a panelist on volatility trading, and he graciously agreed to be interviewed by me.

What is your educational background, and how did you start your trading career?

I got a Ph.D. in theoretical physics, studying the transition from quantum to classical mechanics. I always had intended to become a professor but the idea became less appealing once I saw what they did all day. At this time Nick Leeson was making news by blowing up Barings Bank and I thought I could do that. I mean trade derivatives not blowing up a bank (although I could probably manage that as well).

Do you recommend a new graduate with a similar educational background as yours to pursue finance or trading as a career today?

I don't think I would for a few reasons.

The world of derivatives and trading in general is now so much more visible than it was and there are now far better ways to prepare. When I started, physics Ph.D.s were hired only because they were smart and numerate and could pick things up on their own. My first trading firm had no training program. You just had to figure stuff out on your own. Now there are many good MFE courses or you could do a financial economics Ph.D.

Further, it would very much depend on exactly what kind of physics had been studied. I did a lot of classical mechanics which is really geometry. This kind of "pure" theory isn't nearly as useful as a background heavy with stats or simulation.

I think I could still make the transition, but it is no longer close to the ideal background.

You have been a well-known options trader with a long track record: what do you think is the biggest obstacle to success for a retail options trader?

Trading costs. Most option trading ideas are still built on the Black-Scholes-Merton framework and the idea of dynamic hedging (albeit heavily modified). Most pro firms have stat arb like execution methods to reduce the effective bid-ask they pay in the underlying. They also pay practically no ticket charges and probably get rebates. Even then, their average profit per option trade is very small and has been steadily decreasing.

Further, a lot of positional option trading relies on a large universe of possible trades to consider. This means a trader needs good scanning software to find trades, and a decent risk system because she will tend to have hundreds of positions on at one time. This is all expensive as well. 

Retail traders can't play this game at all. They have to look for situations that require little or no rebalancing and that can be limited to a much smaller universe. I would recommend the VIX complex or equity earnings events.
As an options trader, do you tend to short or long volatility?

I am short about 95% of the time, but about 35% of my profits come from the long trades.

Do you find it possible to fully automate options trading in the same way as that stocks, futures, and FX trading have been automated?

I see no reason why not. 

You have recently started a new website called FactorWave.com. Can you tell us about it? What prompted the transition of your focus from options to stocks?

FactorWave is a set of stock and portfolio tools that do analysis in terms of factors such as value, size, quality and momentum. There is a lot of research by both academics and investors that shows that these (and other) factors can give market beating returns and lower volatility.

I've been interested in stocks for a long time. Most of my option experience has been with stock options and some of my best research was on how these factors affected volatility trading returns.Also, equity markets are a great place to build wealth over the long term. They are a far more suitable vehicle for retirement planning than options!

I actually think the distinction between trading and investing is fairly meaningless. The only difference seems to be the time scale and this is very dependent on the person involved as well, with long-term meaning anything form months to inter-generational. All I've ever done as a trader is to look for meaningful edges and I found a lot of these in options. But I've never found anything as persistent as the stock factors. There is over a hundred years of statistical evidence, studies in many countries and economic and behavioral reasons for their existence. They present some of the best edges I have ever found. That should be appealing to any trader or investor.

Thank you! These are really valuable insights.

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My Upcoming Workshop


Momentum strategies have performed superbly in the recent market turmoil, since they are long volatility. This course will cover momentum strategies on a variety of asset classes and with a range of trading horizons.

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QTS Partners, L.P. has a net return of 1.25% in August (YTD: 10.44%).

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Reader Burak B. has converted some of the Matlab codes from my book Algorithmic Trading into Python codes and made them open-source: https://github.com/burakbayramli/quant_at.

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Follow me on Twitter: @chanep


24 comments:

Anonymous said...

Hi Ernie,

why do you calculate the strategy returns as ret=positions.*(op-cl)./op;
on your gapFutures_FSTX.m code? Isnt it supose to be (cl-op)./op?
This is from your second book.

Ernie Chan said...

Yes, you are correct. Another reader has pointed that out to me before. So this (Example 7.1) is actually a mean reverting strategy instead.

Thanks,
Ernie

Anonymous said...

Hi Ernie,

At page 175 in your new book, there is a formula.

g(f) = < log(1+fR) >,

May I ask where you get this formula?

Thanks.

Ernie Chan said...

To measure the instantaneous compounded growth rate of a portfolio, we compute its log return.
The log return is by definition log(1+R), where R is the "net" return (price(t)-price(t-1))/price(t-1). If we use R to denote the unlevered raw return, then fR is the levered raw return, where f is the leverage. Hence the log return per period of a levered portfolio is log(1+fR). The expected log return is therefore just the average of log(1+fR) over many periods, which is also called the expected compounded growth rate.

Ernie

Anonymous said...

Hi Ernie,

Thank you for the explanation.

Is this still Kelly formula?

It seems Thorp's paper only provides closed form solution.

Would you please recommend references which discuss Monte Carlo or historical methods in details?

Thanks.

Ernie Chan said...

Kelly formula is derived assuming compound returns, hence it must use log returns. It is designed to maximize expected compound returns.

In my book Algorithmic Trading p.177, I discuss numerical optimization of historical growth rate, not using analytical formula or making Gaussian assumptions. Hopefully that's what you are looking for.

Ernie

Royi said...

Hi,
Could you please make you files available as ZIP files on your file instead of one by one?

Thank You.

Ernie Chan said...

Hi Royi,
I am afraid a zipped file of all the files will exceed the maximum size that our web host permits.
Ernie

Anonymous said...

Hi Ernie,

Could we trade based on factor model?

Would you please recommend some references?

Thanks.

Ernie Chan said...

Yes, you can trade with factor models, but the holding period tend to be longer. Search for keyword "factor model" on my blog. See in particular my reference to the paper by Lyle and Wang in http://epchan.blogspot.com/2015/07/time-series-analysis-and-data-gaps.html.


Ernie

Anonymous said...

Hi Ernie,

How do we find SIC codes for US stocks?

Fama/French industry classification is based on SIC codes.

Thanks.

Ernie Chan said...

Compustat database has that information, though it may require a subscription.

Ernie

Anonymous said...

Hi Ernie,

Is the performance of factor model better than pairs trading in stocks market?

Thanks.

Ernie Chan said...

There are many different factor models and many different pairs trading model, so I don't think a general statement can be made. However, factor model is typically for longer term investment, sometimes even long-only investment. You can't really hold long term investments in a pairs model.

Ernie

Anonymous said...

Hi Ernie,

How big is the capacity of stocks pairs trading?

Thanks.

Ernie Chan said...

Capacity of stock pairs trading depends on the universe of stocks and the holding period. For stocks in the SPX, and holding period measured in weeks, the capacity can be hundreds of millions of dollars.

Ernie

Anonymous said...

Hi Ernie,
You mention that the return of the "QTS Partners, L.P. has a net return of 1.25% in August (YTD: 10.44%)"' but on your website I see the fugure for August 2015 is -2.59%. is it an typo?
Thanks

Ernie Chan said...

Hi,
If you read my website carefully, you will see that the returns are for the FX Managed Account only. QTS Partners, LP is our commodity pool, which trades more than 6 strategies, and its net return in August is 1.25%.

We welcome investors to either the Managed Account (high leverage, high risk, high return, undiversified), or the commodity pool (low leverage, very low risk, low but very consistent return, diversified).

Ernie

Anonymous said...

Thank you for the clarification Ernie.

Anonymous said...

Hi Ernie,

What is the definition of ROE and log(ROE) in Lyle and Wang's paper (cross section factors model)?

Thanks.



Ernie Chan said...

Copying from the latest version of their paper:

"Gross annual ROE is calculated as ROE(i, t) =(1 + X(i,t)/Book(i,t-􀀀1)), where
X(i,t) is Net Income before Extraordinary Items (variable ib from the fundamentals file) and
Book(i,t-􀀀1) is the lag Book Value of Common Equity (variable ceq from the fundamentals
file)."

The fundamentals file is the Compustat Global and Compustat North America data.

Ernie

Unknown said...

Hello, Thank you for all this informations.
Actually I found a broker but he asked me a copy of my credit card (just showing the last 4 numbers, name and expiration date), a copy of my ID and some bank acount informations so that I can transfer my profits to my bank account. Is it normal? Should I do it or it's too risky?

Ernie Chan said...

Every broker requires personal id in order to even open an account. I am surprised you didn't have to supply those before. All brokers have to compile with Anti-money Laundering regulation s.

Ernie

Imane Charifa Beddiaf said...

Well he asked me those ID to open an account, and when I explained that to my banker he told me not to do it so I get confused.
Thanks again Ernie