Tom Preston: I love talking about probabilities.
Tom Sosnoff: Do you?
Tom Preston: I love talking about density functions.
Tom Sosnoff: You probably do. You and Jacob have this little, there's not that many people in the world that really care about density functions. And then the two of you could probably lock yourselves in a room and…
Tom Preston: Oh, we exist.
Tom Sosnoff: You do exist. You have very similar backgrounds.
Tom Preston: Well, no. He's way smarter, he knows way more math than I do. Here's the deal.
Tom Sosnoff: You think he's the smartest person you've ever met?
Tom Preston: That's not how I think about it. I mean I know, it all depends on what he knows.
Tom Sosnoff: I know your mind's not nearly a s…
Tom Preston: You know what the difference was? Is? I think he's studied math a lot longer. I had to figure out that … Well, I didn't have to figure out the density function for the normal distribution. But that's something that when I started trading that I could program into Excel or whatever the spreadsheet program was 25 years ago. That's something I could handle and try to make money with. That's the difference. I didn't try to push it out to, let's say, “Okay, now let's go look at …” I don't know what it is he's working on, some weird geometry stuff.
Tom Sosnoff: Yeah, I have no idea.
Tom Preston: Shapes and wacky stuff. That I don't do. I can't do that.
Tom Sosnoff: I always go back in my head and think if we knew anything back when the markets were far less efficient would it have made a difference? Like …
Tom Preston: Oh, if we had had Jacob 30 years ago?
Tom Sosnoff: Yeah, yeah. Well, only in the sense that, I for sure know I wouldn't have bought as much stuff. I probably would have thought differently about, um, about, just about the way we manage..
Tom Preston: I would have been more confident in picking fights.
Tom Sosnoff: Really?
Tom Preston: In other words, in seeing, “You know what? This is useless information. This is a waste of time.” I didn't know what a waste of time was. Most of the stuff that I tried to learn or read or listen to. It has taken a lot of time for us, personally, to ask all the questions. That's really what it is.
Tom Sosnoff: I think there were certain trades throughout the years that I made, that I had no clue as to, or I didn't think about like what those were doing for, what those meant to everything else I had on. So, I think that I took so much risk in different situations that was so damn stupid as opposed to kind of like … I took dumb risks instead of smart risks. I didn't sell enough stuff at the right levels.
Tom Preston: I wouldn't call it dumb as much as uninformed. You can take a trade … okay?
Tom Sosnoff: What's the difference?
Tom Preston: There is a difference. In other words if you can attach a probability to it, I don't care what you think the stock's range is. I don't care if you think its five bucks, one, I don't care what the analyst says. As long as the analyst can say what I believe there is a thirteen percent chance of it happening. Okay. Good for you. Good you believe that? Okay. That I can, that you can work with, but its saying that it's going to go up five dollars without any attached probabilities or what's the realistic risk? Talking about this with Liz and Jenny yesterday. What's the realistic risk? You know what if a terrorist attacks? What is this happens? What if that happened? Who knows?
Tom Sosnoff: No. No, of course not.
Tom Preston: You have no idea so you just rely on the probabilities as the exist right now.
Tom Sosnoff: How could you do anything else?
Tom Preston: You can't!
Tom Sosnoff: That's right I understand.
Tom Preston: Because eventually … what's the point?
Tom Sosnoff: The most interesting discussions I had once I got off the trading floor into the business of building retail software and also talking to customers was that whole discussion of, well what difference does it make after today? In other words, you put this position on because you've got this great statistical change of you know everything makes sense.
Tom Preston: And it changes.
Tom Sosnoff: And it changes.
Tom Preston: Stock price moves, time passes, alterity changes, the probability changes.
Tom Sosnoff: Of course! And they're like so how's that, what does that mean it's only relevant today. And I'm thinking to myself, yeah, but …
Tom Preston: That's okay!
Tom Sosnoff: That's more context than we ever had before.
Tom Preston: That's right. That's right. As opposed to, “Yeah, so I been doing this analysis and the price earnings of the stock ratio when I buy it is this. Now it’s that.” WAHHHH! It’s the same bloody question.
Tom Sosnoff: So I went on to think about all the kind of really successfully traders that I know throughout the years that were consistent way more so than kind of a scalper mentality. The answer was that I'm not sure to what level they were able to calculate all this in their heads, but it was some level that I wasn't …
Tom Preston: They had an intuitive sense of it.
Tom Sosnoff: That's right. They had an intuitive sense of it that I didn't have or any of my friends had.
Tom Preston: No, I had to figure out the formula to figure it out. I couldn't see it in my head.
Tom Sosnoff: Okay, so far today we have been very quiet. The NASDAQ is ridiculously strong, it’s up twenty handles but the S&P's are weak, they're down two bucks, and the DOW is down sixty. The Russ is up a buck.
Tom Preston: Aww, I hate the NASDAQ.
Tom Sosnoff: The NASDAQ is just so brutal. Tesla, BIDU up, Facebook up, Netflix up again, Apple up, Starbucks up.
Tom Preston: Bonds basically unchanged. Bonds are down two. What are notes doing … notes are …
Tom Sosnoff: They're down.
Tom Preston: Three ticks, that's no big deal.
Tom Sosnoff: So, I got filled. That beep that went off while Jacob was talking was the Solar City, which happened to rally while Jacob was talking and we kind of just hung out and waited for that to rally. I don't know where, let's see where Solar City is now. I'll find it. Yes, it is fifty-three seventy-nine. That's actually a huge rally. Its rallied about a buck and a half. Anyway, so we took ours off for fifty cents, so we put it on for even and we took it off for fifty cents. That means for every one line you make fifty bucks, ten lines you make five hundred bucks.
Tom Preston: Good trade.
Tom Sosnoff: That's a good trade. That's a good earnings play. So, we had two earnings plays last night. One we made fifty cents, one we made eighty cents and good job and now we move on to the next day. Move on to the next day. We still have one outlier from the day before which was the earnings play in Fossil which is now up to eighty-five dollars which is good for us. We need a little rally there. Now we just got to let premium …
Tom Preston: Work its magic.
Tom Sosnoff: Yes, work its magic.
Tom Preston: Market measures.
Tom Sosnoff: Market measures. We're running a little bit late so we'll move quickly here. This is liquidity and implied volatility accuracy.
Tom Preston: I have never thought about it in this way. This is a very good piece I think.
Tom Sosnoff: A ton of info today on some heavy, heavy topics. If you're new to tastylive it's not always this heavy. Today is heavy. Again, I like the challenge part. So we often stress the importance of liquidity when trading any product. In fact, the other night when I was having my discussion with Dylan I said, as I always do, number one single most important factor when it comes to trading is liquidity. Single most important thing.
Tom Preston: Liquidity trumps all.
Tom Sosnoff: Then, after liquidity there's all these other things that have to fall into line. But if you're not looking to liquid underline, and if you don't believe us, at the end of the year go back and look at your successes and your failures. Last year, you know, my best stocks were the most liquid stocks. Facebook, Tesla, and whatever else, I can't remember, Apple. It always works out that way for almost every single investor. Your most successes in life are all your most liquid attempts at investment. It doesn't matter what they are. Could be a liquid condo, whatever it is. It's the liquid stuff that just kills you.
Tom Preston: This might explain why.
Tom Sosnoff: Yes. Just a short little story, I've got a friend, he's done very, very good in his career. He's just been very successful. He's a liquidity freak. He doesn't own anything that's not liquid basically. That's been his whole MO for his whole life. So, he buys a piece of property in some other country, and because he wanted to, he thought it'd be cool. Not crazy, he just thought it'd be cool.
Tom Preston: Just something to do.
Tom Sosnoff: All he ever talks about is not being able to get rid of this piece of property.
Tom Preston: This thing hanging around his neck.
Tom Sosnoff: He's like, “All I ever talk about, all I ever stress with anybody … I've ever talked to is how you got to be liquid.” And he goes, “Here, I could have rented this place for this and now I'm stuck owning it for this, forever!” I can never get out. And he's like, “I just didn't listen to myself.” And we all make those mistakes.
Tom Preston: Of course.
Tom Sosnoff: Even if we're crazy about that stuff. My mom once bought a … I begged her, don't buy this timeshare. She goes, “We got a free trip and we're not going to buy the timeshare, don't worry.” I go, “Mom, I know you guys. You're going to buy the timeshare. You can't say no to somebody. I'm telling you right now these guys are professional sales people. She goes, “We're not stupid. We have, you know, multiple degrees, and she's doing the whole thing.” “Mom, I know you do, okay?” “I know you guys do, but listen, trust me, these sales guys are, they trump …”
Tom Preston: They're better than your degrees.
Tom Sosnoff: They're better than your degrees. Okay? You don't know, they're really good. She goes, I'm not going to buy a timeshare. And, what happens? That weekend she goes, “I know you told me not to buy a timeshare but we couldn't pass up this offer of a holiday week. It’s beautiful, its sunny, its warm.” I'm like, “Oh, my God. I told you.” Now all she talks about with her sister, “I can't believe I have to pay these fees and the value is zero.” Talk about illiquid investment. You ever …
Tom Preston: Your mom is a prime example of liquidity. Of what not to do.
Tom Sosnoff: Do you know how many people have learned about liquidity through timeshare investments? It’s got to be millions. I assume there has to be millions of people …
Tom Preston: Let's make a note for the research department.
Tom Sosnoff: There has to be millions of people that have bought …
Tom Preston: Our research team could figure that out.
Tom Sosnoff: That have bought worthless timeshares …
Tom Preston: Sitting on worthless products ….
Tom Sosnoff: Basically.
Tom Preston: … and they're paying for it.
Tom Sosnoff: They always tell you there's a secondary market. “Oh, its exploding. You're going to make a fortune.” Then of course the only person that gets rich off timeshares is Marriott.
Tom Preston: Of course.
Tom Sosnoff: That's it. There's a fat guy behind a chair somewhere at a Marriott going, “We sold another three. Another two today.”
Tom Preston: I love that illiquidity.
Tom Sosnoff: Yes, anyway, let's look here. So, we stress liquidity. It’s all about liquidity. Liquidity, liquidity, liquidity. So, why do we only trade liquid products? More efficient option markets, more efficient derivative markets, easier to trade in and out of, giving up less edge getting in and less edge getting out. Of course. So, how do we measure whether a stock is liquid? Stock and option volume, open interest, tight bid/ask spreads. All the normal stuff.
Tom Preston: The standard stuff.
Tom Sosnoff: Okay, so in picking underlyings in which to base this discussion, we looked at fifty different stocks. According to data from January 2000, according to the latest data from January 2015, we chose 25 of the most actively traded stocks in terms of option volume and open interest. Now again, remember, we get the statistics directly from CBOE. They actually publish, I think it’s the CBOE, but they publish the most active option stocks and so we figure that's the place to go. [inaudible 00:11:38] is the 150 top most active, here we took the 25 most active and then as well as the 25 of the least actively traded stocks, with a minimum of 50,000 contracts traded throughout the month. So, they couldn't be stocks that like nobody has ever traded before and the markets are four dollars wide. We said, okay, as long as you traded 50,000 a month, it’s a reasonable number.
Tom Preston: Yeah, it’s not like nothing.
Tom Sosnoff: So it’s the worst of the best. Essentially. The best of the best as far as liquidity goes. So, as a general guideline for non-earnings plays, these are the maximum acceptable bid/ask spreads. Again, this is just a generalization. Don't read too deep into this.
Tom Preston: Right. The guys put some sort of structure on the test.
Tom Sosnoff: That's right. So max bid/ask spread under $50 a nickel, 50 to 100, twenty cents, a hundred plus, fifty cents. I thought those numbers … just to give us enough room to make this interesting.
Tom Preston: Enough structure, right.
Tom Sosnoff: I didn't even know what they were doing when I gave them those numbers so it wasn't like this is something planned or we backed into it. For starters we compared the bid/ask spread of our first out-of-the-money put in the March cycle for the two groups. So, the first thing we did is liquidity metrics. The average bid/ask spread in the high volume stocks, four cents and the low volume stocks, ten cents. So, we didn't go crazy and find the wacky things. This is really going to help everybody because this is low volume on actively traded underlyers with 50,000 contracts …
Tom Preston: Yeah, this is like the S&P 500 stocks that don't have great options.
Tom Sosnoff: Right, but they do trade.
Tom Preston: Yes.
Tom Sosnoff: So the max bid/ask spread is twenty cents on a $473 stock and on the low volume its seventy cents on a $675 stock. Just to show you. So we're not like … a $675 stock could be, that could be probably CMG or something. We're not going off into like these crazy names you've never heard of. So the minimum bid/ask spread is one penny on a $128 stock, that's probably Apple, and then …
Tom Preston: No, not a … Well, yeah, $128.
Tom Sosnoff: Sure, this is Apple. And then one cent on an $8 stock, who knows, that could be that could be Cliff or something. I don't really know. Groupon, Cliff, something like that. So, the total slippage cost of trading one option contract of each stock, that's the first major take away from this study, is $106 versus $252.
Tom Preston: That's amazing.
Tom Sosnoff: That is. This is trading one option contract of each …
Tom Preston: That's real life dollars.
Tom Sosnoff: Yeah, yeah. That's just slippage.
Tom Preston: That's where the losses come from.
Tom Sosnoff: Of course.
Tom Preston: That's exactly what it is.
Tom Sosnoff: Of course.
Tom Preston: You see those losing trades, down a hundred bucks. Down this or that or whatever. There's a hundred and what? A $148 dollars difference.
Tom Sosnoff: So you want to set yourself up, this is long been one of my pet peeves about this business and about investor education and the way we traditionally teach it. Like, Tim Knight, I'm going to use Tim as an example. I'll pick on Tim for a second. But I'll pick on Slim and other people like that too in the same voice. One of the reasons that you can't look at a thousand stocks is because even if you find a stock that you love, alright, there's not enough liquidity in that underlying …
Tom Preston: Exactly, right.
Tom Sosnoff: To trade it no matter what.
Tom Preston: It’s not worth trading.
Tom Sosnoff: That's right.
Tom Preston: There is always your idea, your idea is never so good, your intuition is never so correct that its worth trading an illiquid product. Find a similar stock with a high correlation that's probably in the exact same situation as your pet, right, and trade that one instead. Always go with the liquid choice no matter what you think you might know.
Tom Sosnoff: So, I'm going to tell you one more brief little story. I'm late but I have a couple seconds. We were doing a conference once somewhere and a guy walks up to me and he tells me how active a trader he is and blah, blah, blah, and all this kind of stuff. And he says he watches, I don't know, 1500 stocks. He's got 8 screens, something like 8 screens, 1500 stocks. He's going through this whole discussion with me and he's going through this whole thing and he goes, “How many stocks do you watch?” There was a lot of people around him, because it was a very public … we're just talking at a trade show. I go, “Well, I got a total of 40. My market view has 40 names and that includes futures. But 28, 29 stocks, maybe 10, 12 futures, something like that. So, total of 40 names.” He looked at me and he's like, “How could you trade with 40 names?!” I looked at him and I go, “How could you trade with 1500?!”
Tom Preston: You do if you make 50/50 bets all day.
Tom Sosnoff: If you do. Right.
Tom Preston: If that's all it is. 50/50, 50/50, 50/50 …
Tom Sosnoff: It’s even worse if …
Tom Preston: Yeah, because you've got $146 of slippage. Well, if you do your options.
Tom Sosnoff: $125. It doesn't matter. Same thing. The vig is so great you can't make money no matter what.
Tom Preston: That's right.
Tom Sosnoff: Okay. By the way, four years later, four years, after that thing.
Tom Preston: He comes back.
Tom Sosnoff: He came back to me and said, I now understand trading. It was a year or so after we started tastylive. And he came back to me, he wrote me the coolest note. And he said, “I had no idea. I thought you were a nutcase.” He goes, “I had no idea what you were talking about back then.” He goes, “You're right. I couldn't make any money. I thought I was a genius but I was just a bold market. Whatever.
Next, we want to look at the accuracy in the probabilities of the options of these two groups of stocks. So, if the options aren't liquid the prices are further from "fair value", which means that the probabilities are potentially less accurate. To test this we looked at the actual versus expected moves on all fifty stocks in every month of 2014. So we went back, we gathered 600 occurrences, and remember the 50 stocks, the top 25, the bottom 25 of that top group. Then, in every month, we went back and just looked at it, so basically the number of occurrences is 12 different occurrences.
Tom Preston: Yeah, so starting on the first of the month, ending at the end of the month.
Tom Sosnoff: So, what we end up with is implied volatility accuracy metrics. High volume stocks that theoretical percent inside the expected move, 68%, the low volume stocks 68%. Now what's interesting about this is it shows that, it shows how amazing, how durable …
Tom Preston: Volatility is.
Tom Sosnoff: I take that back. But …
Tom Preston: It works even in somewhat less liquid products.
Tom Sosnoff: When you start getting into the derivatives of or the percent inside the expected move, you talk about 65% versus 55%.
Tom Preston: Oh, you know what? I misread that. That's theoretically [inaudible 00:18:45]. My mistake. I thought they both landed in the 68%.
Tom Sosnoff: No, so what they're doing is they're just giving you the actual, the one standard deviation. They're saying, what percent, because you're supposed to be more accurate with more liquidity which is the argument we just had with Jacob.
Tom Preston: That's what you’re seeing here.
Tom Sosnoff: That's what you see 65 versus 55.
Tom Preston: So what this means is, one standard deviation out from your current price looking out one month, one standard deviation up, one standard deviation down. Going out 30 days later and seeing where the price landed, did the stock price land inside that predicted range or outside. More liquid stocks landed in their 65%, a little less than their 68% predicted, but again, these are, a lot of equity is in here. That number goes up with index products; 55% though for the lower …
Tom Sosnoff: Almost a 20% difference. Percent of stocks inside the expected move more than 50% of the expected time. 24 out of 25 in the liquid underlyings, 14 out of 25 in the non-liquid underlyings. That's your argument right there. Now to take that just, take that out one step, and if you were walking through a casino with you and your buddy, and your buddy says he knows the odds on every single game, every single game, you're not playing the game with the lowest odds.
Tom Preston: Of course not.
Tom Sosnoff: We don't think of it that way because you go to play a game like, what is it? You could be playing like, Caribbean stud poker. I think it’s like an 18 or 20 percent edge against you versus black jack which is a couple percent. So, your buddy goes, “This is a dumb game to play because there's a 20% edge to the house.” You go, “Okay, then I won't play it.”
Tom Preston: No matter how fun it looks.
Tom Sosnoff: Or, “I'll play it for just $2. I'm just going to mess around, and you know. That means I'm not going to play.” Because you listen. But when it comes to investing we're like, “Oh, no, no, no, no. I really think this stock's going higher.”
Tom Preston: This stock has such a great story. How can you say no to this? You've done so much research. Janet Yellen herself loves this stock.
Tom Sosnoff: I just played golf with the CEO of this company and he loves his own company.
Tom Preston: That's right.
Tom Sosnoff: Yes, so, I guess my point here is there's so much value in liquidity as proven from this, just this brief little discussion here and …
Tom Preston: I've never seen it done like this.
Tom Sosnoff: No, we need to take this and we need to just every time somebody says, “Hey Tom. It’s more important to study, because remember we're still fighting the demons of … You should be going out and reviewing their balance sheet. You should be doing your fundamental research. You should be doing your technical research.” There's no such thing as technical research unless you get to the point where first of all, you're in a high volume stock, which makes it even tradable.
Tom Preston: Right. Exactly.
Tom Sosnoff: This is the part that has always driven me nuts.
Tom Preston: Liquidity trumps all.
Tom Sosnoff: That's a great job by these guys putting it together. All right.
Tom Preston: We'll be back in …
Tom Sosnoff: We'll be back in 2 minutes. We have “Good trade, bad trade” and then we have our bootstrapper.
Tom Preston: All right.