Trading the drama
Intrade created a contract on the economic bailout. Thursday morning, it was trading at about 80, meaning an 80% chance that there would be a bailout by September 30th. I decided to try out a new theory. Suppose we look at the economic crisis not as economists, but as writers. How would a writer finish this story? The answer is obvious: everybody lives happily ever after, BUT: first, there will be some kind of last-minute problems that have to be overcome. The writers will jerk us around a few times, and the deal will be on again and off again. No problems, no drama.
Translating the drama into a price scenario, I decided that the price would drop, and then go back up. I put in a buy order at 70 and waited. Sure enough, “stuff happened”. McCain got all mavericky and rushed to Washington for a photo op. The price went down and I got the contract. I put in a sell order for 85. The next day, the bailout was back on, and the contract sold. Could I do it again? Just before the debate, the price went down again and I bought the contract back for 67 and put in another sell order for 85. After the debate, the price started up again and by Saturday evening the contract sold.
So here I am after two round trips and a 30% gain. It’s Sunday morning and the price is around 65 again. The temptation is to go for a third round trip, but the closer the contract gets to expiration, the riskier the trade. I’d hate to have a contract expire at zero on September 30th only to have Congress approve a bailout on October 1st.
Enough excitement. Time to reflect. Psychologically I’m more comfortable with arbitrage. In other words, I trust math more than drama. On the other hand, the drama trade was dramatically more profitable. Maybe there is some middle ground with enough risk management to make me comfortable, but still with a greater return than arbitrage.