Monthly Archives: October 2014

The Daily View : A Nation or Crybabies and Why Airlines are a Good Investment

With the exception of the midterms riffraff, we’re still in a slow news zone, especially that Ebola is fading (so much for those bogus CDC predictions of ‘millions dead’ or the ‘we are doomed’ rhetoric from talk radio and liberal media). With the S&P 500 up 70 points in 3 days, stocks are back in ‘always go up mode’, and I am profiting greatly from this. Dow 18,000 soon. Same for those web 2.0 valuations and Bay Area real estate. Don’t think they are going lower, because they aren’t. As IQ becomes more important than ever, everything will keep going up with no end in sight. Biological determinism means that the cognitively fittest for prosperity/survival in this unending economic boom will reap the bulk of the benefits while everyone else falls between the cracks. Libs want the world to be doomed so that the rich, including the cognitive elite, lose money.

There are several caveats. Computers are cheaper and have more advanced hardware than a generation ago, but because software has also become extremely bloated, new computers don’t feel much faster. Once everyone has fast computers, developers make software optimized for fast computers. Then you have all the extraneous costs to go with the computer such as internet and software, both of which have gone up much faster than inflation and in many instances costs more than the computer itself.

From Murray and National Review: Why Has the College Board Gotten So PC?

The first is the annual hand-wringing over stagnant scores — a woe-is-us effort spearheaded by the College Board itself, which publishes and sells the SAT. According to the Board’s press release, only 42.6 percent of SAT-takers meet its definition of college and career readiness, and this presents a “readiness challenge” that has persisted for years.

It is any coincidence that 43% is also roughly the percentage of people who score less than 100 on an IQ test? It’s not about ‘college readiness’; it’s that 50-75% of high school students are simply not smart enough to benefit from college – a reality the left is unable to accept because it conflicts with their ‘nurture centric’ worldview. Generations ago, the majority of people didn’t go to college, and this was considered acceptable. Now everyone has to go, so don’t be surprised when many drop out, leaving with no extra lifetime income gains for their efforts and indebtedness.

It seems like this liberal is unclear of the concept of a meritocracy and a free market: High-Tech Chutzpah
Silicon Valley seeks to suppress wages.

This article is more evidence we’re becoming a nation of crybabies. Low wages are better for the economy than having people be overpaid to perform work that can be in-soured, automated, or outsourced. In meritocracy, people are paid for the economic value they create, and no more. Furthermore, restricting labor options is the antithesis of free market capitalism and makes American technology companies less competitive. It’s ironic how the libs want to put people to work, but oppose high tech immigration to the very people who do want to work. The left greedily wants all the jobs to themselves, provided they pay lots of money, have huge benefits, and employers are unable to turn a profit.

Programming is more important than ever. Code is the building block of modern civilization.

Airlines have become a great investment opportunity. It’s like everyone say airlines are a bad business, but AMR, Delta and United are killing it big time by constantly raising prices. Thanks to pricing leverage and globalization, airlines, along with Google and Facebook, have become the best business of all. When all these ‘experts’, including Warren Buffet, say Airlines are bad business, that’s when you got to buy airlines. Nothing is ever that obvious. People, especially businessmen, have to fly, because they have no choice. They ain’t going to boat across the ocean or take a train. In the post 2008 hyper-capitalist era, Airlines have become the perfect business, and it’s only going to get better. The volatility, terrorism and oil shocks of the past 40 years are over for good. David Tepper, one of the most widely followed fund managers, has been bullish on airlines for awhile and has made huge returns.

Anti-Democracy, Part 2

Marc Andreessen is right:

I think the American system is incredibly well developed. I think the founding fathers were geniuses. I think the founding fathers had lived under effective ­government, and it was called King George, and they did not like it. I mean, they knew what an autocratic government was like. And so they implemented a representative democracy, with the representation layer as a buffer against autocratic change and against mob rule. The other thing I don’t like is direct democracy. This proposition system we have in California is craziness, just lunacy. The last thing you want to do is put the mob in charge.

Let the smartest, richest, most accomplished people decide how the country is run because they stand to lose the most if things go wrong. A person with a net worth in the billions has a much greater personal vested interest in the economy and America succeeding than someone with no money and a room temperature IQ.

Agree 100%:

It’s not just paleoconservtives who want the fed to prematurely raise rates; many liberals do too, to combat wealth inequality. Thus, raising rates – like raising taxes – is just another way to soak the rich by destroying wealth. Conservtives who implore the fed to raise rates and end QE are no different than libs who want to raise taxes; the end result is the same: rich people lose money. Marc Andreessen, who voted for Romney, probably also agrees.

The Grey Enlightenment, despite being a right-wing/libertarian blog, supports the fed because fed policy has been a resounding success at creating economic conditions conductive to the creation of wealth so that in America’s meritocracy the smartest and most-talented can thrive. The same for bank bailouts, which also helped the best and the brightest. The libs whined that the dollar would crash, there would be hyperinflation, or that tax payers would have to pay the bill; as Matt O’Brien tweeted, none of those things happened. The super-effective bailouts were essentially free, but indirectly created trillions of dollars of wealth in the form of rising asset prices and technological innovation. Web 2.0 and Silicon Valley owes some of its recent success to the fed, by letting easy money inflate the valuations of these rapidly growing companies and the real estate of the region. Tax payers didn’t pay a penny for the bailouts. In fact, defying all doom and gloom, the treasury turned a profit just three years later, and those who stayed in stocks and real estate were rewarded with the biggest bull market ever. In 2008, thank congress for coming together in the eleventh hour and rising to the occasion when many on the left sought failure.

The motivating factor behind good policy is: we have a finite amount of resources (time and money); let’s allocate them to those most deserving (high IQ individuals, Wall St., web 2.0) who can produce the most ROI. Giving more money to low-IQ economically disadvantaged people is a waste of resources that will only perpetuate the poverty problem. America’s Fed policy has been so successful that other countries have emulated it to combat their own economic problems.

As shown by the bank bailouts, sometimes the best policy is the least popular, and this is just another argument against democracy in that most individuals are not economic stakeholders and have no clue about what is best for the economy.

Optimal Allocation of Public Resources in a Meritocracy

Poor kids who do everything right don’t do better than rich kids who do everything wrong

How would you explain then the rise of all these hugely successful web 2.0 companies and their employees, few if any come from wealthy families? I hate to be the bearer of good news, but the meritocracy is alive and well. Even all the Ivy League schools have very generous financial aid programs. The uncomfortable truth is people succeed and fail because of differences in individual intelligence, with less intelligent people tending to remain poor when adjusting for parents wealth.

Also, the graph shows that poor college grads still do better than the rich high school dropouts, so it’s not so bad. 20% of poor college grads join the top 20% vs. 14% of rich high school dropouts. 21% of poor college grads enter the top 60-50% versus just 5% of rich high school dropouts, again another blow to the author’s argument. This author is too blinded by his biases see the contravening evidence, even when it’s right in front of his nose.

Perhaps the government should give no string attached scholarships for only the best and brightest, instead of the system we have now where tax payers help subsidize the higher education of the dull and mediocre, who are also the most likely to dropout.

The Jeffersonian democracy is an inherently democratic idea, that individuals have free will. Biological determinism, a concept which Charles Murry himself supports, means we as individuals have much less control of our fate than many of us may want to believe. This is still compatible with market libertarianism under a federal government of some sort whose purpose is to ensure that in a free market, public resources are allocated most efficiently and to maintain the state of law.

Some argue that biological determinism means we need more social programs to help those who are incapable of helping themselves. Liberals and some republicans alike argue that everyone is capable of anything, if they try hard enough or other environmental factors. Liberals say that people can live to their full potential with more government help; conservatives believe people can thrive with less government. Both of these are wrong because they fail to take into account the biological differences that exist between individuals; consequentially, both sides of the political divide waste inordinate time and resources applying the wrong solutions to long standing problems that are biological in nature. The idea behind market libertarianism is that you combine both of these ideals: let the free market run on its own, but the government exists to help create economic conditions conducive to the creation of wealth, which is essentially the system we have today. But we can take it a step further by cutting resources to those biologically incapable of advancement and diverting those resources to the more biologically able; this would be a more efficacious use of resources. Cut entitlement sending and give the savings to high-IQ immigrants so they can create the next Google or Tesla.

We need less democracy and more free markets. Instead of a constitutional republic we should have a technocracy or a plutocracy. Only people with a certain threshold of Reddit Karma, a sufficiently high IQ, a net worth in the top 1%, more than 5,000 Instagram or Twitter followers, or a STEM degree should be allowed to vote.

SVXY Strategy: Part 2

Read part 1 **

This post discusses a path dependent model to make large returns with SVXY call options. It’s assumed you are familiar with option trading and volatility funds.

SVXY, unlike XIV, has a complete option chain going as far as Jan 2016. For the first part of this post, we will focus only on the furthest in-the-money Jan 2016 $28 call option, highlighted in yellow:

This option expires in approximately 15 months and has $5 of extrinsic value and a delta of .86.

Here’s a proxy for SVXY dating as far back as 2004 (it doesn’t go any further back). As you can see, it periodically rises and falls between 50-100%:

To double or quadruple your money you need to capture one of these upturns.

Here’s a historical chart of the VIX dating back to 1995:

As indicated by the circles and lines, there have been seven spikes above 40 and many more in the 30′s.

Putting the two charts together we see a pattern:

A VIX spike to 30 causes SVXY to fall in half.

A spike from 45-55 causes it fall in half again, a total loss of 75%.

A super-spike, such as in 2008, results in a 88% or more drop. There have only been two super-spikes in recent history, which was in 1987 and 2008. So these are very rare.

So time to create an investment strategy to capture upside from SVXY and protect, and even profit, from downside.

Let’s assume you have $50,000 in your account and SVXY has fallen 50% from it’s recent high (like it has now).

If we want to buy $18,000 worth of SVXY at a present price of $52 using the highlighted call options, you will need 4 contracts at roughly $28 each; this costs about $11,000. This is derived using: 4 (contracts) times 100 times 52 times .86 (delta)

Ok, so now you wait for SVXY to rally, as it typically does after these falls. If within the next 15 months (the duration of the option) it doubles or quadruples, you make profits of $18,000 and $36,0000, respectively. But you have to subtract $2000 (400*5) for the extrinsic value for the contracts.

What if the market crashes some more? Fist, the option will not fall as quickly as the stock; instead it will gain more extrinsic value. So if SVXY falls from $50 to $25, the $28 call may drop to $10, so you only lose $7,000 by being long four call options instead of losing $10,000 if you were long 400 shares. (to get exact numbers requires use of the Black Scholes equation)

If SVXY falls less than 50% from your buy point, ride it out. Unless the market tanks again, it will eventually go higher.

If it falls another 50% (a vix spike above 45), buy another $18,000 worth using $11,000 worth of deep-in-the-money call options, like in the previous step. So if the present price of SVXY is $52 and the peak is $93, we would be looking at a decline to $23-25 (75%). Presumably, you would be able to buy twice as many options, but the quantity doesn’t matter provided you keep the extrinsic value to around $2,000, leverage at $18000, time until expiration around 1 year, and the purchase cost to $11,000. Essentially, you’re doubling down.

Here’s a diagram of how the strategy evolves:

So even with a large market decline, within 21 months you should be able to increase your initial account size by 64%.

But what about the rest of the cash that hasn’t been deployed into options?

Let’s assume a major crisis like 2008 or 1987 and the VIX spikes above 80, in which SVXY loses 88% of its value and falls to $12 (this is keeping in mind that such events are extremely rare, having only occurred twice in a fifty year time frame). Let’s also assume that the first batch of purchased contracts expire worthless and the next phase of the crash takes 9 months, bringing SVXY to $12. The second batch of contracts you purchased are worth $3000 at this stage, bringing your account value down to $31,000. Just buy 2,000 shares or $24,000 worth of SVXY outright (no options), leaving you with $7,000 cash left over. It would not be too unreasonable to assume that within the next 6 months SVXY rebounds to $25. Your $24k becomes $48K. The $18K second batch is worth $16k (taking into account the $2,000 extrinsic value). Adding it up your account balance is $71,000. Not bad for a market crash. The reason why you buy the stock instead of options is because it’s very unlikely SVXY falls lower, but there is a possibility it won’t recover for awhile and you don’t want to deal with the possibility of options expiring worthless or losing money due to extrinsic value decay. At such depressed levels, the stock is simply a better value than the options.

Also, volatility has a nice property which is that it typically requires exponential* (second order effect) of downward movement in the stock market to make volatility rise a linear amount, similar to the Richter magnitude scale. So even if the market continues to fall, volatility may not rise anymore, which is what happened in 2009 and 2002. In the 2000-2003 bear market, for example, the VIX spiked to 40 as early as 2001 an never went above it even as the stock market kept falling for another two years. The reason why the vix didn’t spike is because the rate of decline of the market was steady. For the vix to really spike, you must have sudden, big drops. That’s why the SVXY doubling down strategy is better than a doubling down strategy with the S&P 500 because with inverse volatility funds you have the logarithmic property of volatility working to your advantage, which limits the potential losses on SVXY even as stocks keep falling. In October 2008 when the S&P 500 plunged 20% in a single week, the hypothetical backtested XIV fund made a low and didn’t go much lower despite the S&P 500 falling another 30%.

** In light of recent market events, an update on the strategy.

* Let’s assume a stock is falling linearly like y=mx+b. The first derivative is a constant, which means volatility is constant – even as the market is falling. If you have a second order decline like y=ax^2, the volatility does rise linearly

State of the Market and Playing Ebola

I was wrong about Ebola…3 people in America have been infected, contrary to my prediction that there would be no further cases besides Eric Duncan. So now there is the possibility things will get worse – more infected individuals, fear and panic that will spread faster than the virus itself.

The solution for investors is a barbell strategy: keeping abundant cash at hand to buy the dip, far out of the money index puts should things get out of control, and deep in the money call options to take advantage of possible upside.

For example, you can buy 5x deep in the money SPY calls that expire on Jan 2015 for $10,000 which enables you to effectively control 500 shares of the SPY ETF, or approximately $90,000 of the ETF at just 1/9 the cost of buying it outright. The fee for this is the extrinsic value which may be $4 or so per contract (look it up on the options table). The downside is if nothing happens, you lose the extrinsic value ($2000). But if SPY surges 10%, you make $7000 ($9000-$2000). Profits, like going long the index, are unlimited. If the market gets annihilated you can only lose up to $10k and no more.

Before investing in options, do the necessary reading to familiarize yourself with how they work.

If the market crashes say another 10% or so, you can buy XIV or SVXY (inverse volatility) to take advantage of the diminishing returns of going long volatility at extreme levels of volatility. Again, this can get pretty technical. Do the required reading to understand how volatility instruments work before you buy. Or you can go long 5 more SPY contracts with the same procedure as earlier.

The barbell strategy involves buying 20 far out of the money SPY puts for every five deep in the money SPY contracts you own. The cost in extrinsic value is around $500 a week for 20 contracts that are 5-8% out of the money, but should the market crash on Ebola becoming pandemic they can easily be worth $30,000 or more. A long-shot, but unlike easier media generated crisis like Greece and Spain, Ebola is real and theoretically can get worse in America. A dozen or more sick Americans will grip the country in fear, causing business activity to possibly seize up. The market will crash worse than in 2008 if this happens.

Europe slipping into a full-blown recession has the potential to make the market go lower, but Ebola spreading in America is a far worse situation.

Crude Oil Sell-off Only Temporary

Liberal celebrations of falling oil and gas prices will be short lived, as history has shown that for the past five years every violent sell-off in oil is met with an equally intense surge. In the last two instances crude oil fell into the 80′s, the price rebounded vigorously:

Why are oil and gasoline prices falling so much? Fears of economic in Europe and global deflation are the usual culprits. Plunging stocks and a rising dollar are also to blame. Here’s what’s going to happen: when stocks finally rebound, so will oil and gasoline.

Contrary to leftist belief, any added ‘purchasing power’ from falling oil is offset by economic weakness elsewhere; there is no ‘net positive’ associated with falling oil prices. Second, all consumer spending is the same whether it’s oil, healthcare education, or plane tickets. The left thinks that somehow money that is spent on gas doesn’t count as consumer spending – it just goes directly into the coffers of the greedy oil companies, I suppose. There is no such thing as a ‘superior’ form of consumer spending. In the end it all goes into GDP.

This recent 5% selloff in equities isn’t the beginning of a 2008-type crash. In 2007, the housing market was unraveling and you had signs of global recession. Numerous important financial institutions both in the US and abroad were close to insolvency. Europe is in a funk, its been that way since 2007, so this is noting new. Meanwhile, in the USA, you still have blowout profits & earnings for six consecutive years, record consumer spending, no hints of problems in the financial and housing sectors, steady GDP growth, good demographic trends, rapid technological progress and free market capitalism. The majority of the most innovative and fastest growing tech companies originate in Silicon Valley, home to Facebook, Snapchat, Apple and Google. You won’t find recession there. Bay Area real estate keeps making new highs in all-cash bidding wars between the Nouveau riche tech employees, rich foreigners, and private equity.

Software, web 2.0 and productivity is making the world flat by creating new industries, changing existing ones and destroying obsolete ones. Wealth creation is pervasive, yet for many unobtainable. The unparticipatory wealth creation boom leaves many losers in its wake.

Stocks Continue Plunge

Update:

The major indexes (S&P 500) is 7% off the record high of 2014, the biggest decline since the taper fears of 2013 when the market fell about 7% as well.

The markets have lost 5% in the past three trading day alone – the worst 3-day drop since 2011.

The ‘E-word’ is on everyone’s mind right now. Is the second infected hospital worker the beginning of a full-blown outbreak in America? Shit will get ugly fast if more Americans get sick, but the likelihood is still slim. Ebola combined with European recession fears probably contributed to the large sell-off.

Buy the dip, but expect a lot of volatility. Favorite picks as usual: MA, V, GOOG, FB, TSLA, JNJ, BRK_B (Berkshire Hathaway Class B shares), XLV (health care ETF), PJP (biotechnology ETF)

Is political correctness really rampant online?

Actually, since 2008 or so with the rise or Reddit, 4chan and internet libertarianism and HBD, we’re seeing a repudiation of political correctness by many young adults. During the IQ wars the majority of people online, especially on high-IQ sites such as Reddit and 4chan, sided with the politically incorrect biological deterministic point of view. This backlash in and of itself is worthy of more attention. The internet and social media is one of the last bastions of free speech, which is why the left is threatened by Facebook, Google and Twitter and seek to spread fear about the NSA and privacy concerns to scare people from going on the internet.

Like their rejection of certain biological inconvenient truths, the Libs only support the free speech that advances their egalitarian world view. Sam Harris, despite being an atheist, is right about some liberals being as indoctrinated as religious Islamic fundamentalists. Fundamentalism comes in many forms, welfare liberalism is one of them. The good news is neoliberalism (liberalism with a brain) is replacing welfare liberalism.

The Daily View: STEM Bailout, Elizabeth Warren, James Altucher

Thank the fed, the consumer, free markets, tech entrepreneurs in Silicon Valley, defense spending, and the ivy league for America being exceptional – as much as the libs, in their war on success, want America and its great economy to fail.

In America’s post-2008 hyper-meritocracy and high-IQ society, The software engineer is the most important person in the world right now. That’s why for months I have been posting about the STEM bailout which is a basic income for anyone with an IQ above a certain threshold and or anyone with a degree in a useful field such as engineering, English or physics. Useless fields, such as art history, would not be applicable. High-IQ people are the most likely to succeed, so why not give them a basic income so they can focus their talents on various economically fruitful endeavors (e.g., creating the next Facebook, Google or Tesla) instead of having to worry about paying the bills?

In the smartist era, wealth (as measured by savings and stock equity, not ostentatious possessions such as fancy new cars) and intellect is more valued than ever.

Elizabeth Warren, who talks funny with lots of umms and ahhs, never passes on the opportunity to regale the world with her ignorance of economics, with this quote:

That’s right. They protected Wall Street. Not families who were losing their homes. Not people who lost their jobs. Not young people who were struggling to get an education. And it happened over and over and over.

Job loss is a byproduct of technological innovation. If you majored in something useless, don’t be surprised if you cannot find work commensurate with your accreditation.

It’s easy for people, especially liberals, to project their cynicism about the system or society by making blanket statements. For some folks, I suppose, It’s comforting or cathartic to believe everything is doomed or the world is run by idiots. As shown by the super-effective bank bailouts, QE programs, Katrina and the post-911 response, policy makers, when they rise to the occasion, are more competent than commonly believed. According to a consortium of economists, including the famed Robert Barro, the Obama stimulus was an abject failure while TARP, despite being very unpopular, was a resounding success.

From jamesaltucher.com 10 Reasons You Should Never Own Stocks Again

The best way to take advantage of a booming stock market is to start a company. Because everything goes up. If you have an extra $50,000 don’t put it into stocks. Put it into yourself. You’ll make 10,000% on that instead of 5% per year.

This advice ignores the fact that that majority of small businesses fail within five years, or that the vast majority of many small businesses that do survive don’t return anywhere near 10,000%. For every Facebook, Starbucks or Walmart there are thousands of businesses that either fail or are just treading water. Many of these businesses that do survive don’t even turn a profit. And if James’ reasoning is sound, by recursion, why not take that 10,000% return and do it over and over? After, like, five iterations you’ll have all the money in the world lol. 5% a year? That sure beats a negative 100% return in a failed small business. You make much more money and with much less effort not trying to create a doomed-to-fail business but by investing in already successful businesses, and you’ll sure as hell make more than 5%. You could have bought Facebook stock at $22 a few years ago and easily tripled your money (200% return). Or invested Facebook in 2005 as Peter Thiel did, and became a billionaire with just a few hundred thousand dollars. You could have invested in Snapchat a year ago and tripled your money. The point is, investing in yourself is a terrible idea when you can make much more money with far less effort investing in existing successes. James is right about the economy being fundamentally sound and about stocks going higher, but this is bad advice.

Market Update

With the exception of the recent rout in stocks, we’re still in the what is perhaps the slowest news cycle in almost a decade.

Three weeks later and still no new US Ebola patients, exactly as I thought it would be. That’s why I quit listening to right wing talk radio (and all media in general). A bunch of idiots trying to scare you so they make more money from advertising.

The left hopes the hacked Snapchat photos will discourage people from using the app, and hence cause the valuation of the start-up to plunge. No such luck, stupid libs. The people who use Snapchat don’t care that much if their photos are leaked; they are using it because it’s convenient, not so much because of the anonymity. Month ago, Snapchat also brushed off massive spamming attacks and leaked phone numbers. Once these social networking apps are viral, they are invincible to pretty much anything.

Is Snapchat another Myspace? The left said that about Facebook, Twitter, Uber, Dropbox, Tinder, Pinterest,..the list goes on and on. For every huge failure like Myspace, there have been dozens of huge successes and Snapchat is one of them. Snapchat will be worth $40 billion within a year or two, owing to huge growth and monetization potential. Even at $10 billion valuation everyone wants a piece of it, which will only drive the valuation higher and higher until it is eventually bought out or goes public. If it goes public at $40 billion, its valuation will double on the first day of trading making it an $80 billion dollar company. Not bad considering it was worth $80 million just a few years ago. It will be obscenely overvalued by any metric, but the price won’t fall much. At that point the S&P 500 will be at 2,500 or so. Facebook will be a $170 stock. Tesla will be $700. Uber will be worth $100 billion. I guarantee that by next year Tinder will be the next $10 billion dollar app. The list goes on. As Bay Area real estate keeps going up 10-30% a year, the left will be having fits about why this ‘bubble’ refuses to pop despite ever widening wealth inequality and low labor force participation. The post-2008 high IQ hyper-meritocracy is just getting started, and nothing short of divine intervention can stop it. Imagine a world where IQ is the most important predictor for success at life – oh wait, that world exists. You’re living in it right now. America is becoming richistan. Smartism everywhere. People are getting richer than ever.

A couple months ago, I tried a new investment strategy of creating a linear combination based portfolio of funds, resulting in a very high Sharpe ratio. So far, it’s worked out great. With the market down 5% off the highs, my portfolio is only off a tad:

Flawed Argument for the Legalization of Insider Trading

A common belief by proponents of the legalization of insider trading is that insider trading can help expose frauds so that the ‘little guy’ doesn’t fall victim to the next Enron or Worldcom. The idea is that insiders, privy to the fraud, will sell their shares and cause the stock price to fall to its ‘true’ value, which in the case of Enron would be maybe a few dollars instead of $90 before the fraud began to unravel. Disregarding the dubious ethics of insiders profiting off frauds that they themselves may have helped instigate, let’s deconstruct the argument that insider trading helps protect the retail investor.

From Washington Post Insider trading enriches and informs us, and could prevent scandals. Legalize it.

From Reason Magazine Insider Trading Is Really Common. Awesome!

Markets work best when goods are priced accurately, which in the context of stocks means that firms’ stock prices should accurately reflect their strengths and weaknesses. If a firm is involved in a giant Enron-style scam, the price should be correspondingly lower. But, of course, until the Enron fiasco was unearthed, its stock price decidedly did not reflect that it was cooking the books. That wouldn’t have happened if insider trading had been legal. The many Enron insiders who knew what was going on would have sold their shares, the price would have corrected itself and disaster might have been averted.

This is an overoptimistic assumption. The chart to scalar theory says that insider trades can theoretically be detected if the stock underperforms an index, but a sufficiently large counter-inflow from buyers in the context of hype surrounding the stock or from an underlying bull market may mask insider selling. If an insider dumps 1m million shares and and another person buys 1 million, legalized insider trading won’t necessarily reveal potential nefarious activity. Even if insiders sell everything, it may just not be enough shares to make the price fall appreciably.

Let’s assume that company insiders tell friends and family and maybe even hedge funds about the impending bad news. Those newly informed individuals would do one of two things: sell the stock short and or buy put options. To an outsider, this activity would be be manifested in many ways: the stock becoming ‘hard to borrow’, elevated volume of put contracts, a steep volatility smile, put/call parity violation due to strong negative skew. But here’s the catch: there are many stocks that have these characteristics and the overwhelming majority are not frauds. In fact, there is some evidence that heavily shorted stocks can outperform the market due to the short squeeze:

So using these ‘telltale’ signs of informed trading can lead to too many false positives.

The easiest way the ‘little guy’ can avoid disaster is to buy index funds.