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SHLD option pricing -- strange


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In Aug 2006, we bought FFH Oct 2006 calls on the theory that the hurricane season would continue to be benign because hurricanes follow a fractal pattern rather than the normal distribution that guru forcasters assume. When the stock ran up, we cashed out and used the profits to buy leaps. Result: a 30 bagger :) We are not tempted to try this with SHLD. Unlike FFH, SHLD appears to be stuck in a toaster. Walmart put them into Cpt. 11. Next episode: Cpt 22

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Hurricanes and stock markets have a distribution

that isn't normal or bell shaped. There are periods

of low incidence or volatility punctuated by shorter

periods when everything goes bonkers.  It's hard

to predict when these "regime changes" will occur,

but the important thing to keep in mind is that

whatever phase you're in is likely to continue.

There isn't a smooth transition and regression to

the mean is jerky.  In fact the very idea of a mean

is flawed. It's better to think of each phase as

having it's own mean.  The most important

observation is to realize that whawever phase you're

in is likely to continue for a time that may often

be estimated by reference to historicle records.

Therefore, the volatility or severity of that period

is highly correlated with recent events and very

little with the events of the previous regime

immediately before it.

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Here's more about how this idea of the fractal

pattern of hurricane distribution in the Gulf of

Mexico and western Atlantic has worked very

profitably.  2005 was the worst hurricane season

ever: 6 major hurricanes making landfall,

including Katrina.  Property rates in exposed areas

and natural disaster retro rates increased by a factor

of 6.  We wanted a piece of this but we didn't want

to get burned,so we waited to see how the 2006

season developed.  By late August, the season was

a zero, nothing! Every storm that started to develop

or come close to the US had it's top blown off or

was blown away from the US by contrary winds.

This was the type of pattern of low risk associated

with an El Nino but the hurricane forcasters had not

detected an El Nino and were still predicting a very

bad season in ignorance of the implication that a

fractal regime change had likely occurred. We decided

to act.  We bought large amounts of Lancashire

Holdings because their new CEO, Richard Brindle, had had

by far the best record at Lloyds of London returning

@ 26 percent per annum to the Names who invested

in the syndicates for which he was chief underwriter

in the 80's and 90's. His forte is assessing catastrophe

risk/reward.  We also bought FFH calls as detailed

in the last post.  These were dirt cheap because of the

short attack against them.  The shorts thought that another

bad hurricane season was likely and that this would

finish them.  We thought this unlikely.  The rest is

history! PS: We did the same thing this year too,for the same reason, adding

even more to these two great companies that now amount

to about two thirds of our portfolio.  :)

a bad hurricane would finish 




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Yes and no. It can't be predicted with very high probability

that a regime change has occurred until you can look back

in time and see the demarcations between the regimes. 

However, it makes sense to recalibrate probabilities

when a regime change MAY have happened. With hurricanes

in the Gulf & W Atlantic, a sudden shift from high

incidence in one season to zero or ultra low incidence

in the first half of the next season is the hallmark of

a dramatic event, an El Nino effect. Therefore, in

2005, by mid season, there were two possibilities

that were becoming increasingly probable with each

passing day with no hurricanes threatening US shores

:  a regime change to a more benign period of

several years ( typically 12 to 17 years) and or

an El Nino effect that may last for no more than

one year. When the 2005 season was almost

over, the forcasters finally lowered their probabilities

after they had firm evidence that there had been

an early arrival of an El Nino.



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