By Robert Hunter

It's not every day somebody comes along claiming that all of options theory is bunk. But that's exactly the idea proposed by Nasser Saber, an adjunct professor at New York University and general partner of Saber Partnership, a trading and risk management firm.

In his latest book, Speculative Capital & Derivatives: The Nature of Risk in Capital Markets (Financial Times/

Prentice Hall, 1999), Saber audaciously declares that, from the earliest days of economic inquiry to the present, every piece of literature and university lecture on options has been flat-out wrong. Oh, and the few times options have been priced correctly in the marketplace are the result of dumb luck.

The General Theory

Is an option really an option? The classic definition of an option is the right, but not the obligation, to buy (call) or sell (put) an underlying asset for a certain price. But Saber argues that in this definition, the literal meaning of the word option is mistaken for the nature of the beast. In fact, there's no choice involved in the process. "If I sell you an IBM call and IBM goes through the roof, do I have the right not to deliver? Not really. I have to deliver. What happened to my right as the seller?” Options, he says, are always defined from the point of view of the buyer. Why? "There's no answer for it.” Even shifting to the holder's point of view, the absurdity persists: "If you own a call that's out of the money, you're not entitled to anything; if it's in the money, you have to exercise the option. Not to exercise would be like a lottery winner not collecting his prize. It's irrational.” So what is an option? The right to default on a forward. For the long, that right is called a call; for the short, a put. Saber explains. "Take IBM. It's at $120 right now. You think it'll go up; I think it'll come down. That's our bet. You're long, I'm short. You think that the IBM call you're writing for $5 gives you the right to buy IBM. But, in fact, you're already long in the contract. In paying $5, you are prepaying your potential default. If IBM drops, you don't have to pay the money, even though you are long. Why not? Because you have already paid the so-called premium, which is the cost of the default of the long. That's what a call is. Conversely, for the short, it's called a put—the cost of default of a short contract—when it rises in price.” This reading of options, Saber says, dispels all their theoretical and practical inconsistencies and paradoxes. For example, take the contrarian nature of the put/call ratio on stock index options. When the ratio of puts to calls on a stock index increases, the conventional wisdom goes, it should imply a bearish sentiment. It has been generally observed, however, that such an increase is followed by a rise in the market. Because the logic of the change in the ratio is inconsistent with the observed events, it is said to be a contrarian signal. But the call and put are the prepaid cost of default of longs and shorts in a forward. When the put/call ratio increases, it means that more shorts and fewer longs have prepaid their losses because they anticipate the market rising. In that case, both groups have taken a prudent action: shorts because they have prepaid a loss that could increase with a market rise, and longs because they have not rushed to prepay a potential loss that would decrease with a market rise. The opposite is true when the put/call ratio declines. The actions in markets and the indicator of those actions are logical and consistent. But because options are misunderstood, Saber says, this logical relation is misinterpreted as a contrarian signal. —R.H.

Saber, a true iconoclast, speaks in absolutes. "The tenured professors of finance in Ivy League universities are as much in the dark about options as the small-time players who regularly risk a few hundred dollars in the options market in the hope of striking it rich,” he declares. "The celebrated authors of the Black-Scholes-Merton formula were no different—they did not understand what it was that they had found a solution for. In concentrating on the technical aspects of calculation without analyzing options properly, they led the study of options into a blind alley in which logical contradictions and the absurdity of the assumptions used to explain them only multiplied with the passage of time.”

Saber says he is the only person to understand options completely (see box). He has created what he considers to be the first intellectually valid options pricing model, and is busily developing a trading system to put the model to work—an undertaking he believes will guarantee huge profits for him and immediately revolutionize the options business.

According to Saber, the current options-pricing orthodoxy is laughable. "We're told that a bull and a bear will always agree on a fair price for an option. So if you're paying $5 for an option, whether you're a speculator or a hedger, it's a fair price. But you're paying $5 in return for what kind of benefit? You think that when you're buying a call the sky's the limit, because IBM can go to $1 billion. But that $5 isn't calculated based on the $1 billion—if it were, the value of the call would be something like $500 million. You're paying $5 for it because it's calculated based on the maximum potential downside of IBM. But as I show in my book, you're paying $5 for a maximum profit of only $3—and that's not a smart thing to do. You are entering into a bet in which you'll lose $5 to win $3. You play this game enough times, and you're out of money. That's what's being done right now in the financial markets.”

"The celebrated authors of the Black-Scholes-Merton formula led the study of options into a blind alley in which logical contradictions and the absurdity of the assumptions multiplied with the passage of the time.”

Saber says his model, which is discussed in the book, and his forthcoming trading system will change the landscape of finance forever. "When we release our system,” he says, "you will see the relationship between the interest rate and an option, between a strike price and an option, and between everything else you thought you knew and you really didn't know.”

Saber intends to target the system, which doesn't yet have a name, to day traders, who "will kill over it.” The system, he claims, will also solve the most pressing problem facing financial institutions and central bankers—counterparty default risk quantification.

He's been using the system for the last year to manage his firm's assets, with considerable success. "Last year I had most of our money on Apple options. It started at 36 and sold at 105, so that's 300 percent. It sounds like a crap shoot, but it wasn't. It was based on this model.”

Will the multibillion-dollar options market embrace Saber's radical ideas? Only time will tell.

The options world suffered a loss in January when James Kipp, a former chairman of the board at the Chicago Board Options Exchange, died at the age of 64.

Kipp was a founding member of the CBOE and also served as chairman of the board and executive committee in 1977. He was a member and market-maker on the trading floor from the time the exchange began in 1973 until his recent retirement at the end of 1999. Kipp also served as a governor at the Midwest Stock Exchange from 1970 to 1972.

Kipp was known as a walking encyclopedia of the unwritten historical detail of the changing options landscape, and was often used as a consultant and resource for complex issues that arose. His career spanned four decades, starting with LaSalle Bank in 1958. He was a founding member of the Heartland Institute, a free-market public policy think tank for Midwest issues, where he served on the board of directors from 1984 to 1994. Most recently, he was a partner at the Options Funding Group from 1990 to 1999.

• The Pacific Exchange named James Bowe, former president and CEO of the New York Board of Trade, senior executive vice president for options.
• Steve Rattner, former head of high-yield capital markets at Donaldson Lufkin & Jenrette in New York, has moved to London to run DLJ's European fixed-income group.
• Morgan Stanley Dean Witter has named Carolyn Aitchison product manager. She had been in charge of the European high-yield desk at Donaldson Lufkin & Jenrette in London.
• Vincent Ciaglia, former principal and general partner at The III Group of Funds, has joined Global Fixed Income Advisors as managing director.
• Askari has named Andrew Hunter COO. He had been the interim CEO for EMTT Technologies.
• Andrew Filipowski, former chairman and CEO of Divine InterVentures, has been appointed to the board of the Chicago Board of Trade as a public director.
• Bank of America Securities has acquired three new equity derivatives traders. Scott Draper, former director and cohead of listed options trading at Salomon Smith Barney, will be a principal and senior U.S. volatility trader. Nathanial Newlin, former senior index trader at JP Morgan, will be a principal and senior trader of index products. Nick Perry, formerly a principal and options trader at JP Morgan, will be a vice president and institutional equity options block trader.
• Mark Goldman was named head of fixed-income and derivatives sales for Europe, excluding France, at Societe Generale Bank. He had been head of European bond sales at Nomura International.
• Gain Capital has appointed Glenn Stevens head of sales and trading. He had been a managing director and head of foreign exchange trading at NatWest Global Financial Markets.
• Garry Jones has joined BrokerTec Europe as director of sales and marketing. He had been head of global secondary bond sales, trading and research at Daiwa Securities.
• Morgan Stanley has named Robert Voreyer head of its Asian high-yield capital markets group. He had been head of high-yield trading for the bank in Hong Kong.
• Roy Leighton has been elected chairman of the Futures and Options Association in London. He is chairman of the European Advisory Board of Credit Lyonnais SA. Sir Michael Jenkins, chairman of the London Clearing House, resigned as chairman of the FOA.
• CreditTrade has hired two credit derivatives brokers, Bobby Console-Verma, former head of credit derivatives at GNI Financial Products, and Andrew Kasapis, head of the credit derivatives desk at Bridport Investor Services.
• Mike Adams, a former senior derivatives manager at Bankers Trust, has been appointed head of local markets trading in emerging markets at Dresdner Kleinwort Benson.
• Prebon Yamane has announced a number of promotions and changes. Len Harvey has been named Asian managing director. Garry Plithers has been named CEO of the European monetary union region. Tony Verrier has been named deputy CEO of the EMU region and managing director of money markets. Judy Fitch has been named managing director of capital markets and securities for EMU.
• Erwin Martens has been named managing director and head of risk management at Putnam Investments. He had been head of global market risk management, fixed income and derivatives at Lehman Brothers.

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