Derivatives: A PowerPlus Picture Book (with 16MB CD-ROM)

Mark Rubinstein. Available only at www.in-the-money.com. $150 ($75 for students and academics).

Reviewed by Nassim Taleb

Rubinstein was among the pioneers of the first paradigm of option theory. His book propounded such unfamiliar concepts as “gamma strategies” at a time when the other major book read in dealing rooms was Lawrence McMillan’s Options as a Strategic Investment. Option Markets was the first work that popularized probabilistic and scientific methods in options, helping inaugurate the derivatives revolution—but not without some pseudoscience to go with the science. It was later undeservedly supplanted by John Hull’s Option Futures and Other Derivatives, a volume far less insightful but more structured and pedagogical.

In addition, I have other specific reasons to owe Mark Rubinstein a measure of gratitude, having been long volatility during the stock market crash of 1987 and, through thick and thin, ever since. Most people believe the Leland-O’Brien-Rubinstein portfolio insurance program played a dominant and catalytic role in the crash. The crash was the event that taught me to disrespect anyone who claims an ability to “measure” risks.

It would not be exact to call these lines a book review since this is not quite a book, but rather a set of multi-modality package class notes, called Derivatives: A PowerPlus Picture Book. The package richly integrates 382 pages of spiral-bound text with 342 multimedia PowerPoint slides, an extensive WinHelp glossary, several additional documents, abundant software (the Rubinstein Option Calculator), and worked examples. Purchasers have the right to download future versions and additional material from Rubinstein’s web site.

I start this review with a comment on the book’s medium, given its originality. It is truly innovative, which makes it difficult to judge with full fairness, since all this depends on tastes and habits. I tried the three different modalities—the PowerPoint slides, the WinHelp glossary and the spiral-bound book—and comfortably settled on the book (by power of habit). I would have preferred to have the book portion in conventional form rather than spiral-bound given that I used it as the dominant part of the package. As to the software, I found it quite extensive and pedagogical.

I toyed with this package during trading hours, with one eye on my trading screen and the other on the picture book with the WinHelp tool. I found it to be quite an attractive dictionary-style reference. My judgment is therefore similar to the one I have about on-line encyclopedias: they may be useful to many, but some people may prefer the feel of plain old traditional hardcover volumes. One additional feature of the book: it can be entertaining, with a variety of sounds popping up unexpectedly, and animated figures erupting on the screen (I suspect them to be caricatures of Mark Rubinstein). Derivatives even includes a sampling of Mark Rubinstein’s musical tastes—Grieg and Mozart.

One of the benefits of such a medium is that the buyer is not merely purchasing one edition, but all the subsequent ones. This allows the owner to end up with a typo-free version; the author can also instantly (and un-academically) change his mind on a subject (I have a few suggestions for him later in this piece). Rubinstein, unhappy with his previous publishing experiences (many technical authors attest to similar disgruntlement), decided to take matters into his own hands. Who needs distribution when the Internet is right there, one upload away? One worry I would have about this publishing model is piracy, since some of the files—namely, the slides—can be easily copied.

The book sections are organized in eight parts: 1) Introduction, 2) Forwards and Futures, 3) Introduction to Options, 4) Binomial Trees (that is, discrete time), 5) Black Scholes (that is, in continuous time), 6) Volatility (realized and implied), 7) Dynamic Strategies, and 8) Annotated Bibliography.

The book has many positives. First, Rubinstein has characteristically invested a great deal of attention in the details. The book is tight, with definitions and descriptions as clear as one would expect from someone who taught derivatives to an entire generation of students. Second, the book is truly pedagogical, even engaging in places. Flipping through the slides provided me with some measure of entertainment, and even made me laugh a few times. I enjoyed the slides in which a binomial tree unfolds forward with a whizzing sound to show the evolution of an asset price, then rolls backward as the call is priced, with a finale greeted with loud applause.

Third, Rubinstein has his feet on earth. Derivatives is rich in details about factual trading matters, something rarely found in textbooks. For instance, there is a slide showing how to cheat one’s customers (illegally), with a list of the major old tricks, such as cherry picking (in which brokers allocate the winning trades to themselves or to someone like, say, Hillary Clinton), chumming (in which market makers trade against each other to create the illusion of activity) and ghosting (in which market makers collude to push a price in a given direction), something I have not seen in options books before. Note that Rubinstein’s options culture is equities-oriented; he has the language of the less sophisticated CBOE practitioners rather than that of the more scientific financial product professional.

Fourth, the book is, unexpectedly, not too immersed in financial theory, which generally glorifies Black-Scholes-Merton and the overrated continuous finance approach. In the annotated bibliography, Rubinstein presents a history of derivatives thought that gives some well-deserved justice to the various forgotten contributors to the option-pricing formulas. To me, the Black-Scholes-Merton result is not a “breakthrough” invention a la Pasteur, but an apt economic argument that allows options pricing within neoclassical economics. The true inventor was Bachelier. I may start calling it the Black-Scholes-Merton improvement of the Bachelier-

Kolmogorov-Boness formula. Concepts such as complete and incomplete markets, and the first, second, and third theorems of financial economics, have little applied relevance and do not have the odor of sanctity outside of the ivory tower; Rubinstein keeps them somewhat in the background. Still, as a scientific trader, I would have preferred to have Rubinstein treat the subject of options outside of the religious backdrop of the heavily theoretical neoclassical economics.

Fifth, Rubinstein provides a clear discussion of the assumptions behind financial theory, such as the drawbacks of using mean-variance as a criterion for efficiency in the presence of skewness. He offers a clear presentation of the attributes of distributions and shows how skewness and kurtosis can translate into shapes on the option volatility curve.

To conclude the positive points, Rubinstein leaves me with the impression that conventional options theory is a subject he understands intimately, for he discusses it with the simplicity and directness of a master. I have to bemoan my experiences with academics, traders and former academic-quants on the subject, which are often marred by theorem-dropping nonsense and complicated economic arguments that reveal no true comprehension of the generator behind the concept. I have discussed options and derivatives with hundreds of successful derivatives people throughout my 14-year career, and have only felt this effortless mastery with a handful of old veterans such as Marty O’Connell (with options in general), Bruno Dupire (with options mathematics), Howie Savery (with barrier and digital options), and Varun Gosain (with credit products). Rubinstein, as we say on Wall Street about someone who knows options, can connect the dots—a rare attribute in academia. I bemoan, however, that he does not seem as familiar with market dynamics as I would have wished. I wish Rubinstein had a little more scientific realism in his approach.

On the negative side, there are a few minor points. These are merely annoying and, at times, infuriating to a practitioner of the no-nonsense variety. The most irritating one is as follows. There is a tendency among some finance academics to consider that any knowledge not published by their designated journals does not exist. While such a practice can be justified in some disciplines—say, complex analysis or mathematical anthropology—it is less tolerable in financial derivatives, where practitioners of the non-tenure-seeking variety are often years ahead of academia. Not only do they deal with products and techniques of a higher relevance and sophistication than the average derivatives academic, but they are subjected to greater scrutiny from the market. It is high time for academics to understand that there is a difference between the “practitioner” who reads Tom DeMark or Jack Schwagger’s unrigorous and non-testable discourses on technical analysis and the columns of Futures magazine on one hand, and the financial product professional subjected to all manner of scientific rigor on the other.

Rubinstein provides an illustration of the practice of finance professors to stick their names, and those of their colleagues, on a collection of results that are entirely trivial in nature and well-understood in practice, but that nobody bothered to publish before because of their triviality. For example, he writes, “Mark Garman, while he was an active professor at Berkeley, developed a way [c. 1992] to use binomial trees to compute the risk-neutral expected life of an American option. As an inventor of this concept [emphasis mine], he had every right to name it and called it fugit.”

Well, I recall that this “invention” was similar to something options professionals commonly used in the 1980s, when American options were still frequently traded in the currencies—the practice was so widespread that we used it as an interview question. Our method used the ratio of the interest rate sensitivity of an American option priced on a binomial tree to that of the same option of the same strike price on a Black-Scholes model and multiplying it by the nominal maturity. So Garman’s invention was merely the publication of a complicated version of the trick. Incidentally, Garman had his name stuck (no doubt against his will, for he is a first-rate scholar) on an option formula (the “Garman-Kohlhagen formula”) simply by replacing the dividend in the Black-Scholes formula with the foreign interest rate (a brief footnote).

If dynamic portfolio protection does not work, it flows that the opposite may. In other words, the method may work if one is not obligated to sell dips, but has the option of doing so.

The attributions can be excessive in this book, no doubt a product of the financial economics culture. Listing financial options, names are invariably stuck to the discussions, even if the results are beneath trivial. Rubinstein is guilty of overquoting his financial colleagues, referring to papers that are rarely true contributions to merit quoting, or are often too complicated to be appropriate for an auxiliary reading list in an introductory book. He drops too many names between slides 38 and 53. I give a few: automobile leases (Miller), taxation of income (Draaisma/Gordon), liquidity (Beck), fishing industry entry licenses (Karpoff), 401(k) deferred-tax saving plans (Stanton), bull and bear floating rate notes (Smith). Nowhere did I find in the book the slightest hint of the existence of a financial products professional capable of learning anything on his own, in a clinical manner, without help from academic papers or precious advice from his local derivatives academic. While minor academics may need to glorify each other, a practice the Romans call asinus asinum fricat (donkeys rubbing each other), I find it strange to see Rubinstein engaging in such practice, given his clout.

The last topic on my list is portfolio insurance. Rubinstein provides in part seven a theoretical discussion of dynamic strategies, which makes this book different from other options books. I enjoyed his presentation of the distinction between convex and concave dynamic strategies, where the payoff from the stream of purchases and sales in the underlying security can resemble a positive or negative gamma position. In all fairness, he considers some of the weaknesses of portfolio insurance, which I find commendable—but he does not go all the way. He seems to underestimate the evils of execution. Any trader who has been short gamma would know that he is the weak hand, and that a market is like a large movie theater with a narrow door—which explains such underestimation. Although I find it unfair to bring up in a discussion elements foreign to this book—namely, his record of advocacy for portfolio insurance—I have to say that Rubinstein failed to learn from the crash of 1987 the difference between the strong hand and the weak one. A weak hand is someone who is obligated to act in a certain way in response to a market move—like, say, sell after a decline. Such a person can be highjacked by the market. “Show me a reluctant dynamic hedger and they will front-run him until bankruptcy,” I wrote in these pages (December 1996–January 1997). Why didn’t he learn that? Because, at heart, he is not a trader. The idea that comes out of this is that one does not have to be as intelligent and insightful as Rubinstein to become a good trader; it suffices to have enough intelligence to learn to operate a telephone, be extremely self-critical, have the ability to learn from one’s losses, and, above all, observe markets with a clinical, as opposed to theoretical, eye.

If dynamic portfolio protection does not work, it flows that the opposite may. In other words, the method may work if one is not obligated to sell dips, but has the option of doing so. Some aspects of dynamic strategies have been extremely successful, particularly when being used by the aggressor rather than the sitting duck—namely, inverse portfolio insurance. This is the sort of thing legendary traders Paul Tudor Jones and Bruce Kovner might have been doing as teenagers; the concept bears the name of cut your losses and add to your winners or play with the house’s money, not your own. The method has been practiced ever since markets were invented; its math was popularized in William Feller’s famous textbook under the concept of the gambler’s ruin.

Another evil of short gamma strategies Rubinstein avoids discussing is the measurement of rare events. Rubinstein provides some testing of portfolio insurance to illustrate its performance and shortcomings. However, he ignores the effect of the 1987 crash on portfolio insurance, although he presents the simulations results for 1982 when “it failed miserably.” Nor does Rubinstein present the potent economic arguments against portfolio insurance by Sanford Grossman, although the book boasts being about something called economic intuition rather than the math.

To conclude, I am excited to have Derivatives on my hard drive and bookshelf. Overall, this remains by far the most pedagogical and most colorful introductory academic book on options ever written. I am happy to see that another generation of students will be trained by Mark Rubinstein.

Nassim Taleb is a proprietary trader for a financial institution in New York and a fellow in Mathematics in Finance at New York University’s Courant Institute. He is scheduled to co-teach a class next winter on financial model risks. His own web-based book If You’re Such a Good Trader Why Aren’t You So Rich? is serialized at http://pweb.netcom.com/~ntaleb/index.asp .

Capital Market Revolution: The Future of Markets in an Online World

Patrick Young and Thomas Theys. Financial Times/Prentice Hall. $34.95 hardcover.

Reviewed by Angelo Calvello

Patrick Young and Thomas Theys, the authors, are neither futurists nor academics but two “insiders”—two guys who have been in the game and know first-hand the opportunities and challenges that technology presents to those of us in the markets. Readers of this magazine are probably familiar with Young’s web site, Applied Derivatives Trading (www.adtrading.com). Theys was an early proponent of integrating technology with trading floors and, through his company, Personal Automated Trading Systems, provides floor traders with hand-held trading tools.

Yet despite these positives, I found myself struggling to get through this book. While the authors offer many original and thought-provoking insights into a range of topics, they continually overextend the scope of their inquiry and the plausibility of their arguments. Every discussion about how technology will reshape a specific aspect of the capital markets (floor trading, clearing and settlement, regulatory oversight, banking, asset management, and so on) inevitably includes sweeping sociopolitcal conclusions.

Let me cite one example. The authors claim (quite correctly) that technology is having and will continue to have a significant impact on the capital markets. Yet rather than simply focusing on how this impact will manifest itself, they offer a Hegelian view of history and insist that this impact will result in a revolution that will be “so profound in its global consequences for every man, woman and child on earth that it can (and likely will) bring masses onto the street within a decade to overthrow the large lumbering government bureaucracies that have failed to appreciate the paradigm shift in world finance.” The book abounds with such deterministic, hyperbolic pronouncements. (I especially like this one: “In fact, there is nothing that can now stop the Capital Market Revolution from unfolding, apart from a nuclear holocaust destroying the world itself.” Marx could not have said it better himself.)

Such comments do, however, give us an occasional glimpse of this “new reality” brought on by technology.

One insight I found particularly interesting is the authors’ claim that open outcry is “to all intents and purposes dead.” While many may think this is a foregone conclusion, here in Chicago nobody is willing to sell long-dated put options on open outcry. Defenders of open outcry offer all sorts of emotional arguments to buttress this anachronistic trading method. Ultimately, these arguments reduce to one: Technology simply cannot replace the human being in the activity of trading. This may have been the case when Leo Melamed came up with the idea for Globex in the late 1980s, but it is not true any more. Today, technology is available that can accept and execute all sorts of order types. Technology can also handle a crush of volume and spikes in volatility, while eliminating the intermediation and reducing the costs associated with futures trading. In addition, technology offers benefits that open outcry does not: a fully verifiable audit trail, real-time clearing, and a predetermined order-execution scheme. While there may be numerous parochial reasons for keeping open outcry (the most obvious being that the exchanges are owned by individuals whose livelihood is tied to floor trading and whose retirement plan is embedded in the current price of an exchange membership), there are no economic or regulatory reasons not to trade futures electronically, provided these electronic markets are liquid.

The authors then turn their attention to the critical issue of who will provide liquidity in these new electronic futures markets. But instead of viewing technology as a tool (which at root, it fundamentally is), they venture into a discussion of the “new reality.” Technology, they say, will not only change the way futures contracts are traded, but will make possible the transformation of independent floor traders (locals) into e-locals. Locals will adapt to the coming “paradigm shift” and use the available technology to again provide liquidity in these new markets.

If the authors had followed their reasoning to the obvious conclusion, they would have realized that theirs could not be correct. Technology will give rise to new electronic markets, but it is doubtful that it will transform locals into “e-locals.” First, locals are not the most adaptive group of entrepreneurs you will ever find. Members of the Chicago Mercantile Exchange and the Chicago Board of Trade have stymied the exchange-wide introduction of electronic hand-held trading terminals for more than eight years. Second, locals provide liquidity in open-outcry markets because they have an informational advantage: They are on the floor and trade the order flow. Technology does away with this advantage. Success in these new electronic markets will require that traders have some investment process through which they repeatedly extract positive returns from a given market. This process must be independent from the order flow because execution and trade allocation will be based on some algorithm (such as, First in, first out). Few floor traders employ such an investment process, so their migration “upstairs” will be problematic at best (despite the authors’ fondness of “trading arcades”).

The authors further argue that technology will not only allow locals to morph into a higher evolutionary form, but will also give birth to a new species of traders. People who have previously been systematically excluded from participating in the futures markets will now be able to enter the game. Technology will provide these individuals with information that was previously available only to institutions and professionals. It will also allow for immediate access to the markets. (I take this to mean that these individuals will not have to wait until after the close to get the execution price for a pork belly order they placed just after the open.) These individuals will be “the new breed of independent traders who will facilitate trading, be it individuals in tax havens such as the Caribbean or Monaco, or working from large dealing rooms within financial centers, or on the cusp of large conurbations.”

While there may be numerous parochial reasons for keeping open outcry, there are no economic or regulatory reasons not to trade futures electronically, provided these electronic markets are liquid.

Technology may improve the availability of information and make access to the markets more immediate and inexpensive, but it will not create this breed of traders. There are significant barriers to becoming a successful trader that technology cannot eliminate. First and foremost, you need capital—risk capital—and not everyone has this. Second, you need the correct psychological demeanor. Trading is not for everyone (as evidenced by the recent tragedy in Atlanta). Third, you need a viable investment process—a trading system that makes money. These are three substantial barriers to entry. Technology can do a lot of things but it does not make a person smart. Market pundit Alan Abelson addressed this very topic recently when he wrote, “What could be more farcical than the idea that any of us bumpkins equipped with a computer, an on-line connection and a little spare time could make a fortune trading stocks?”

The providers of liquidity will not be individual investors; they will be those participants who already have the capital, skills and trading programs in place—namely, institutional participants like proprietary trading desks. The immediacy and accessibility made possible by technology will enhance the ability of such firms to function as deep, continual two-sided markets. Individuals will continue to participate in the futures markets, but they will be liquidity takers, not liquidity makers.

In the end, Capital Market Revolution fails to accomplish its objective—it never gives us a good look at the future. Yet its shortcomings may be mitigated by the fact that it does succeed in forcing readers to reflect on their assumptions about technology and the future of the capital markets. All market participants would benefit from such reflection. Yet it is the members of the Chicago futures exchanges who most urgently need to engage in such contemplation. This book should be required reading for this audience. It may be just the thing that awakens these men and women from their dogmatic slumber and forces them finally to reckon with the impending challenges facing them. For if they do not embrace technology quickly, the futures exchanges, like the stockyards, will become quaint artifacts of a bygone era.

Angelo Calvello, president of C/79 Consulting LLC, a firm that helps asset management companies build and market investment products, can be reached at acalvello@c79.com.

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