Moontower #129

I accidentally “picked off” my 3rd grader.

[If you don’t know what “picked off” means see Money Angle below.]

The story will improve your numerical intuition and illuminate a lesson that is central to both investing and engineering problems.

The Proposition

My 3rd-grader came home with a packet of math worksheets from school. Two of the sheets, a total of 10 questions, were incomplete. He said the teacher didn’t require those sheets to be done.

What a bummer.

I thought they were the best questions from the whole packet. I asked him to solve the total of 10 questions but decided to make my request a little spicier. I offered him the following bet:

If you get them all correct, I will give you $5. Otherwise, you owe me $5.

He thought for a moment, then accepted. Before he went off to work on them, I started to wonder if my impulsive proposition was fair.

Is It A Fair Bet?

After eyeballing the questions, I estimated he had a 90% chance of getting any question correct. Another way to say that, is I expect he gets 1 wrong on average. Right off the bat,  I think I’m going to win. It’s not a fair bet.

This led me to compute a couple numbers.

  1. If my estimate of 90% hit rate per question is correct, what’s the chance he gets them all correct?

    .90¹⁰ = 35%

    That means he’s almost a 2-1 underdog

  2. What would his hit rate need to be per question to make the bet fair?

    First we need to convert what a fair bet means in math language. This is straightforward. Since it’s an even $5 bet then the fair proposition would not be, on average, he gets 1 wrong, but that he gets all the questions correct 50% of the time.

    x¹⁰ = 50%

    x = .50^(1/10)

    x = 93.3%

    So if he had a 93.3% chance of getting any single question correct, then he has a 50% chance of winning the bet.

Flipping The Odds In His Favor

I’m not trying to take candy from a 3rd grader, I just wanted to make him more eager to do the questions. So, I tweaked the bet after he returned with the answers. Each of the 2 worksheets had 5 questions each. I decided to batch the bet as follows:

If he gets all the questions correct, he wins.

If he gets all the questions in one batch correct but not the other, it’s a push.

If he gets less than 100% on each batch then he loses the bet. 

How did this tweak alter the proposition?

In the first bet, if he got anything wrong, he lost. With these rules, he only loses if he gets, at least, one wrong in each batch.

We need to analyze all the possible outcomes that can occur with 2 batches.

First, we must ask:

What is the probability he gets all the questions right within a batch of 5 questions?

Assume he has a 90% hit rate again.

.95⁵= 59%

So for either batch, he has a 59% chance of getting a perfect score and a 41% chance of getting at least one wrong (ie a non-perfect score).

Now we must consider all the possible outcomes of the proposition and their probabilities.

  1. Perfect score in both batches

    59% x 59% = 34.8%

  2. Perfect score in one batch but not the other

    59% x 41% = 24.2%

  3. At least one wrong in both batches

    41% x 41% = 16.8%

If we sum them all up we get 75.8%.

Wait, these don’t add to 100%, what gives??

We need to weigh these outcomes by the number of ways they can happen.

The possibilities with their probabilities are as follows:

  • Win, Win = 34.8%
  • Win, Lose = 24.2%
  • Lose, Win = 24.2%
  • Lose, Lose = 16.8%

Collapsing the individual possibilities into the proposition’s probabilities we get:

  • Win: 34.8%
  • Push: 48.4% (24.2% + 24.2%)
  • Lose: 16.8%

These probabilities sum to 100% and tell us:

  1. The most likely scenario of the bet is a push, no money exchanged
  2. Otherwise, he wins the bet 2x more often than he loses the bet

This is a powerful result. Remember, his hit rate on any individual question was still 90%. By batching, we changed the proposition into a bad bet for him, into a good bet because he gets to diversify or quarantine the risk of a wrong answer.

Even More Diversification

With 2 batches we saw the range of possibilities conforms to the binomial distribution for n = 2:

p² + 2p(1-p) + (1-p)²

where p = probability of perfect score on a batch

In English, the coefficients: 1 way to win both + 2 ways to push + 1 way to lose both

What if we split the proposition into 5 batches of 2 questions each?

These are the bet scenarios:

  1. Win =  5 pairs of questions correct
  2. Lose = at least one wrong in each of the 5 pairs to lose the bet
  3. Push = and any other combination (i.e. 3 perfect batches + 2 imperfect batches)

How do the batch outcomes roll up to the 3 bet scenarios (win, lose, push)?

  1. We must count how many ways there are to generate each of the scenarios.
  2. We must probability-weight each way.

The summary table shows the work.

[Note the coefficients correspond to the coefficients for the binomial expansion (x+y)⁵ which is also the row of Pascal’s Triangle for N = 5]

The net result of quarantining the questions into 5 groups of 2:

35% chance he wins the bet

65% chance he pushes on the bet

Nearly 0% chance he loses on the bet!

If you took this quarantining logic further and treated each question as its own batch then the new phrasing of the bet would be:

If he gets every question correct, he wins

If he gets every question incorrect, he loses

Any other scenario is a push

The corresponding probabilities:

Win = .9¹⁰ = 35%

Lose = .1¹⁰ = E⁻¹⁰ or 0%

So the benefits of separating the bets were mostly achieved above when we batched into groups 5 pairs of questions.

Conclusion

The first bet required my son to get a string of questions correct. Even though I estimated he had a 90% chance of getting any question correct, by making the net outcome dependent on each chain link, the odds of his success became highly contingent on the length of the chain.

With a chain length of 10, the bet was unfair to him. By changing the bet to be the result of success on smaller chains (the batches) I changed the distribution of outcomes. It did not increase his chance of winning, but it reduced his chance of losing by creating offsetting scenarios or “pushes”. In other words, the smaller chains reduced his overall risk without sacrificing his odds of winning. It was a free lunch for him.

When you create long chains of dependency (ahem, positive correlations), an impurity in any link threatens your entire proposition. In these examples, we are dealing with binary outcomes. This is a trivial analysis. With investing, the distributions of the bets are not easily known.  It is well-known, however, that diversifying or not putting all your eggs in one basket is a free lunch. Still, if the investments are highly correlated, you may be fooling yourself and depending on a long chain.

Imagine if the 10 questions my son had were the type of word problem where the answer to each question is the input to the next. That’s a portfolio of highly correlated assets. If you are “yield-farming” crypto stablecoins you have probably thought about this problem. Spreading the risk across many coins can offset many idiosyncratic risks to the protocols. But is there a translucent, hard-to-see chain of correlation tying them all together that only reveals itself when the whole background goes black? That’s systemic risk. Ultimately, the only hedge to such a risk is position sizing at the aggregate level where you sum the gross positions. This is why stress-testing a portfolio to that standard is a quant’s “last level of defense”.

Jarvis, what happens to my portfolio when all correlations go to one?

[If you are in the investing world you will see parallels to this lesson in the ergodicity1problem.]


Money Angle

In trading, “picking someone off” means trading against a counterparty who would flake on the price they offered you if they knew what you know.

If I lift an offer on a TSLA March call option because I’m bullish, the market-maker on the other side of my trade doesn’t care. They would still sell me the call even if I texted them my rationale. But if I had the divine knowledge that Elon was going to tweet in the next 10 seconds that earnings would be reported in March not February, then I would be knowingly “picking off” the market-maker. As an options trader, you need to defend against pick-offs. You also want alerts if someone else is making a price that is not incorporating material, public info. For example, if an OPEC meeting date was moved there might be a tiny window when you could disguise a calendar spread as a routine roll when really you are trying to pick off the other side before they get the memo.

[In reality, when such news happens, market-makers will “sweep” all the resting customer orders with price limits below or above the option’s new fair value. It’s very difficult to pick off another professional who is consuming a real-time news feed.]

A few categories of pick-offs:

  • Pickoff trades related to changes in dates.

    If earnings are moved from early Feb to early March, then the “earnings volatility” needs to come out of the Feb expiry since you are no longer exposed to it, and the March options which now contain that volatility must appreciate relatively.

  • Pickoffs related to change in carry

    If a stock announces a change in its dividend that will affect the carry embedded in the options. If a dividend is slashed, the calls go up relative to the puts. Market makers need to be on top of how corporate actions affect the inputs into their pricing models.

  • Pickoffs related to changes in baskets

    If an ETF’s constituents change that affects vol of the underlying basket. If an ETF restricts creations, this can lead to the options and ETF becoming mispriced (one day I’ll tell the story of how this personally cost me 6 figures).

Pickoffs In Real Life

The tradition of trading floors is full of insane prop betting stories (NYMEX vets have so many to choose from but my personal favorite was watching one guy successfully pound 20 Coors Lites in an hour in one of the upstairs offices).

But picking people off can be as easy as making bets with folks who are arithmetically challenged. Most people are. You only need to look up polls by @10kdiver to see that even professional investors, a subset of the population who should be able to compute a return, struggle numerically.

I am overstating the case a bit.

  1. I don’t know how many of those respondents to those polls are professional investors. I’d also admit there are times I’m impatient and just take a guess just to see the results. This is probably common behavior.
  2. When confronted with a bet, people’s defenses go up. They are wary of strangers bearing gifts and will assume there’s a catch.

[Today’s Moontower was a re-factored version of this post: I Felt Bad For Picking My 3rd Grader Off]


Job Opportunity

An awesome team (I can’t overstate awesome here) is looking for a full-stack junior developer. You will learn from seasoned quant PM and be part of building a HF from the ground up.

Requirements:

  • Ability to work on full-stack including DevOps
  • Python, JS/React, SQL, Redis

Good to have:

  • C# and experience with distributed systems

This group is very groovy, if you’re hungry and eager to learn and build, it will be an amazing opportunity.

Hit them up here: omk.jrdev@gmail.com


Last Call

Musical Encore

I’m always crowdsourcing music recs. I’ve compiled many of them at Moontower Music. The end-of-year Spotify Wrap is an excuse to compile your favorites.

Humor me:

Notes From C.Thi Nguyen Interview About Games and Society

Link: https://www.preposterousuniverse.com/podcast/2021/10/18/169-c-thi-nguyen-on-games-art-values-and-agency/

C. Thi Nguyen received his Ph.D. in philosophy from the University of California, Los Angeles. He is currently associate professor of Philosophy at the University of Utah. He has written public philosophy for venues such as Aeon and The New York Times, and is an editor of the aesthetics blog Aesthetics for Birds. He was the recipient of the 2020 Article Prize from the American Philosophical Association. His recent book is Games: Agency as Art.

I only excerpted topics of particular interest to me so you should listen to the podcast for a fuller understanding. Anything bold is my emphasis.


Intro by host Sean Carroll

One of the good things about the artificiality of games, you know when you’ve won or lost, unlike life. But…that clarity of knowing when you’ve won or lost is very seductive outside the context of a formal game. It’s very seductive in life.

Thi has developed this understanding to study things like echo chambers and cult leaders. A cult is in many ways like an echo chamber. In both cases, it’s not just a filter bubble where you prevent information you don’t want from getting in, but it’s like a strategy for preemptively undermining claims from outsiders that the cult leader or the echo chamber doesn’t want you to believe in, right? You give people ways to discount outside information.

One of the reasons why cults and echo chambers are so seductive is that they bring clarity to values and moral reasoning, maybe a little bit too much clarity: They make it too easy, they make things cut and dried in a way that the world itself is often not so cut and dried. So he has a whole understanding of why we’re so seduced by conspiracy theories, by cult leaders, by echo chambers, and how it relates to this seductiveness of clarity that we get from thinking about games and point. We get points, we get likes on our tweets, we get steps on our Fitbit. This engages our brains for interesting evolutionary reasons, and that feature of human psychology can be gamed, if you like, by the leaders of cults or echo chambers.

Games

What is a game?

The notion of a game is really disputed in philosophy. It’s very storied. In philosophy, it’s a particularly famous concept, because when Wittgenstein was like, “No, you can’t define concepts,” his example of an undefinable concept was a game.

There’s an amazing book from Bernard Suits called The Grasshopper, which is an attempt to define games, which actually takes itself as a response of Wittgenstein and also secretly about the meaning of life and the relationship between games and the meaning of life.

The short version is, “To play a game is to voluntarily take on unnecessary obstacles for the sake of making possible the experience of struggling against them.”

  • Part of the idea of the game is that the goal of the game is partially constituted by obedience to certain restrictions:

    If you’re trying to get to the top of a mountain to get some rare drug that’s only there, you’re not playing a game. You’re just trying to get to the top of the mountain. If you’re trying to climb the mountain as a mountain climber, then certain restrictions are part of what you’re doing. So the medical seeker is not a game player, and the mountain climber is. And one way you can tell is if someone goes by in a helicopter and says, “Hey, you want a ride?” The medical climber will say, “Of course, get me the cancer drug.” And the other person is like, “Of course not. What do you think I’m doing?”

  • Autotelic: It’s worth engaging in the activity for the sake of the engagement and the doing rather than the product.

The charm or allure of games

  • Struggle

    The aesthetic experience of struggle can be accessed in a safe way by making the difficulty manageable.

Some struggles are beautiful, some struggles are satisfying. And what games do is, they let you tweak the activity to maximize that satisfaction…Most of life’s challenges are too big or too boring and little for us. In games, we get to modify the world of the game and the abilities we’re allowed in the game until they fit just right.

Example:

I feel like things like chess are kind of tuned to maximize that moment, you get more and more of those moments. In my normal life moving around the world, I get to feel graceful once a week, but rock climbing tunes you into the part of the activity that has that feeling. It’s built to constantly call out of you that incredible experience of delicate, graceful, perfect motion.

Manageable because of clarification

Games are these circumscribed spaces where the actions in space have been often been leaned down and clarified, so your actions can fit. They’re clarified, not just because the actions you can perform have been clarified, it’s because your values have been clarified.

Bounded and limited beings make things that make them feel temporarily okay, like spaces where we don’t feel too little for this vast world. The real world is this existential hell-scape of too many values, and games are like this temporary balm, where the world makes sense for a little bit.

  • Games as art

    Games are sculpted experiences of practicality. I think what’s interesting in games is, if games are sculpted practicality, then the beauty emerges in the practical action. So in other words, when you play a game, it’s not the game that’s beautiful, it’s you that’s beautiful.

    I think a lot of the literature about games has been going around looking for qualities that are in the game, like, Oh, the graphics are beautiful, the sound is beautiful, the story is beautiful. And they’re not looking at how radically different games are. And I think there are other things like this that are also mostly neglected, but the thing that makes games unique is that they’re sculpted action.

The danger in having your values clarified

  • Gamification

    Game values are hyper crisped-up, and that’s fine if you put away those values at the end. But when you gamify something like education or communication, then you’re forcing a singular clarified value system on a real-world activity. Think of how Fitbits or Twitter engagement can orient your goals towards local maxima. Twitter’s gamification squashes an individuals’ pluralistic values and gets everyone, insofar as they’re motivated, to be motivated in the same direction.

    • Education examples:
      • Sean Carroll: I used to be at the University of Chicago, which obviously has always been academically super-duper strong, but back in the day, it wasn’t the place you applied if you were interested in Harvard or Stanford or Princeton, it was less well known. So suddenly, there was a strategy that they undertook at the University of Chicago because they were being hurt in the US News rankings, and they were being hurt because the only people who applied to the University of Chicago were the ones who really wanted to go there. And you are rewarded in the US News rankings by having a high selectivity, by rejecting most of the people who apply, so they intentionally encouraged people to apply knowing they would reject them, ’cause it increased their selectivity, and they leapt up in the rankings. That’s an example of maybe the goal perverting the original aspiration.
      • Law School culture
        A study about law school culture when the US News and World Report started ranking them charts a bunch of stuff like what you’re talking about, about people gaming the rankings. One of the things they point out is that different law schools used to follow different missions before the rankings, but if their mission is skewed to the ranking at all, then you drop in the rankings, so it’s forced everyone to pursue the same values.

        Before the rankings, prospective law students used to talk about what different law schools valued and talk about their own values and decide what their values were, to pick which school to go to. Now, they, say 99% of the students just assume their goal is to get into the best school, where the best school is set by the ranking. So they don’t go through the process of value self-deliberation. You end up outsourcing your values, you end up letting somebody else perform value deliberations for you, and what goes into those values are often very much based in what’s in the interest of large-scale institutions and the kind of information management systems at large-scale information.

People worry a lot about games creating violence, and there’s actually a lot of data that mostly they don’t. And I think part of that is that the violence in games is fictional, and we have a lot of information that people are mostly capable of screening off fictions. The thing that I’m really worried about is people becoming used to the idea that the goal is some simple, quantified thing that people share, and what we’re supposed to do is do everything in our power to up that simple measure, and one thing on to note, that’s not fictional.

We shouldn’t worry about games creating serial killers, we should worry about them creating Wall Street bankers.

[obligatory reference to James C Scott’s Seeing Like A State: “Look, what you should think is that large-scale institutions generally see the parts of the world that are processable by large-scale bureaucratic machines, which are quantified data, they can’t register the part.” So, think about this, a large-scale school district or an educational bureaucracy can’t register individual student evaluation data, they can only register aggregatable data like GPA. So, says Scott, large-scale institutions have reason to remake the world along lines that are more regular, so that they can be legible to the institution and actable on by the institution.]

  • The satisfying aspect of games common to conspiracy theories

The satisfaction we crave in the clarity and simplification of games is why we are drawn to conspiracy theories. Conspiracy theories are tuned to give you the exact same pleasure [as games]. Someone has changed the nature of the world, apparently, to make it tractable.

How the argument works:

    1. There’s a source of anxiety: The world is complex

      Scientists are hyper-specialized, no-one understands everything, at some point you realize that you have to just trust tons of stuff that you have no ability to grapple with.

    2. Conspiracy theories circumvent our need to trust

      They say “Don’t be sheep. Don’t trust other people. Here is a vision of the world, where you can contain the world in you. You can explain all of it with this one powerful explanation.” It is a game-like pleasure, but exported to a place where it’s dangerous.

      • Refers to a book by Elijah Millgram, called The Great Endarkenment. It talks about how knowledge must not be individual quest given the fact that the world is so hyper-specialized that no one can know more than a tiny amount of it. [This stands in contrast to the] ideal of intellectual autonomy that drove the Great Enlightenment. But it doomed itself, because it created all the science that made it impossible to be intellectually autonomous. If you still hold to the old ideal of intellectual autonomy, where everyone can understand everything, what you get is being driven to anti-vaxxing and various conspiracy theories in which you reject trust in the sciences.]
    3. Conspiracy theories hack our desire for clarity

      It’s not that clarity is always bad. When you have intellectual success, you do have this feeling of clarity. My worry is the feel of clarity actually comes apart from real understanding, and that outside actors can game it.

      For example, in the course of evolution, it made perfect sense for us to pursue sugar and fat because calories are scarce, it’s hard to get enough fat and so on. Then the world changes and industrial forces figure out that they can maximize the feeling of sugar and fat separate from any nutritive qualities. And then if you’re still stuck on that old heuristic and chasing sugar and fat, then you’re screwed. Clarity can be like cognitive sugar. Someone can aim to max out the feeling of clarity, and the way that looks like is a conspiracy theory.

Trust’s role in conspiracy theories

1. Trust is tricky because there’s a lot you cannot trust, yet being able to trust is not optional

If you devote your entire life to it, you can understand one one-millionth of the human landscape of knowledge. [Even worse] not only can you not understand everything else, you don’t even have the capacity in yourself to pick the right experts to trust.

I have a PhD in philosophy, I have a lot of education. If you gave me a good, a real statistician, and a fake one, I don’t have the mathematical skills to tell the difference between a good statistical paper and one that gives a bad result. I don’t have that in myself. So what you get is actually this incredibly iterated and very fractal chain of trust.

[An example of why we have no choice but to trust in many cases:

There was one proof of a really famous theorem that literally only one guy understood, and he’s getting old, so a whole bunch of people had to have a project to re-write the proof in a way that other people could understand it. And that whole process of dealing with the fact that you need to trust some things, while you shouldn’t trust everything, is a tricky thing that is probably under-theorized.]

Politically, conspiracy theories tend to be associated with the right, but the left’s appeal to science fall flat because they are not appreciating the role of trust:

      • The false argument they spout:

        “Oh, these fucking anti-vaxxers, anti-maskers. Think for yourself, look at the science, evaluate the science.”

        When the truth is “I can’t evaluate that science.”

      • The obstacle is not whether people trust Science with a capital “S”, it’s the trust of its messengers

        Look at the people that are legitimated in a certain institutional structure, which involves a background trust in those institutions. And I think there’s this vision where for a lot of us, like when you look at anti-vaxxing, anti-masking, the climate change denialist space, what we want to say something like, “Oh, those people are totally irrational.” But I think what you have to think instead is, they have an entirely different basic framework of trust, for a different set of institutions. The degree of rationality there depends on the degree to which we can justify our trust in our institutions. And that’s a really, really complicated matter, and it’s not like the authoritative institutions are always right. There are plenty of historical cases where they are corrupted, right?

        It’s hard to be against conspiracy theories as a blanket statement ’cause sometimes there are conspiracies. We have plenty of historical examples where all the institutions in a particular country have become corrupted, have taken over the news media, are issuing fall statements. That’s a real thing that happens.

2. Echo chambers are not about ignorance, they’re about trust

An echo chamber is a system in which people have been taught to systematically distrust people on the other side. The book Echo Chamber doesn’t quite say the world around Rush Limbaugh is a cult, but they basically almost say it. This book is an empirical analysis of the world around Rush Limbaugh — Rush Limbaugh’s top people just systematically distrust and dismiss people on the other side.

This is is different from not hearing them at all (which is the filter bubble argument). The problem goes back to trust, not irrationality or disbelief of science.

A large segment of the population has had their trust subverted and undermined and directed toward what we think of as like the wrong institutions.

The way back is not to wave the evidence in people’s faces. I think people want to be like, “Oh, climate change denialists, just look at the evidence, here is the evidence,” but of course they’re not showing you the evidence, they’re showing scientists that they trust who process the evidence, ’cause not even a climate change scientist, a particular climate change scientist, has looked at all of the evidence for climate… It’s all processed.

Someone whose trust has been systematically undermined in that set of institutions will not trust evidence from sources they distrust**. And that is rational.

This is a complicated problem without easy solutions. But the first step is recognizing the story is that the other side doesn’t hear us. It’s that their trust has been undermined.**

A lot of public policy figures are fixated on the filter effect thinking we just need to create these public spaces where people can meet each other and talk to each other. That’s a standard view in a lot of political philosophy and public policy. And I think that’s not going to work if trust has already been systematically undermined. It doesn’t matter if you meet and hear the other side, if you already have a prevailing story that says they’re malicious, manipulative, evil people.

The grand takeaway

The need for clarity as evidenced by our love of both games and conspiracy theories can cause us to overoptimize and seek safety in echo chambers.

What do we do about it?

While there are no answers some hints that can point in helpful directions:

  1. Transition between perspectives

    Playfulness is the quality to transition between different world perspectives, easily, lightly, to hold your perspective lightly and slip between different ones. This can be done via literally traveling and playing games where you are forced to slip in between different value perspectives.

    It’s hard to do, it’s hard to put on different worldviews as like different outfits. This is a resonant argument for reading and earning widely:

    This is going to become the world’s oldest chestnut, but sometimes I think like, this is what the fucking humanities are for. Read some art, read some novels, motherfucker, and if you want the background paranoid view, it’s something like the world has very good reasons to get us to onboard to super simple, clear targets. And when I look at universities cutting humanities programs in favor of business schools and STEM, because those are higher-earning jobs or lead to more clearly measurable productivity, I’m like, of course, reading weird subtle art, experiencing weird subtle art, including games, but also including novels and music and all this other stuff, is this stuff that might have clued you in to different value perspectives other than make a lot of money and get a good job. And of course, they’re going to get cut out in a world dominated by hyper-simplified institutionalized values.

    One of the suspicions I have is that certain domains, especially the domains that science has a lot of success with, are the kinds of domains that admit of extraordinary clarity. And other domains, like the domain of life value and the domains of personal health and fitness and aesthetic joy, are not domains that admit of the same systemic clarity. And when we demand them, we start hitting simplified targets.

    There’s a difference between qualitative and quantitative data. Qualitative data is really rich and nuanced and subtle, but it’s really context-sensitive. It doesn’t aggregate, it doesn’t travel well.

    [insert quote: Not everything valuable can be measured, and not everything we measure is valuable]

  2. Be aware that there are forces that are trying to manipulate us

Like the sugar analogy, is this moral view or worldview too yummy? Is it just too satisfying? Did someone make this just for me and people in my cohort to swallow down?

This is definitely not a blanket. The thing is, you also get clarity and pleasure from really getting at truths. You can’t throw all that stuff away, you just have to realize that the signal has been amenable to perversion and misuse.

Keepsakes From Slatestar’s Fake Graduation Speech

Link to original post: https://slatestarcodex.com/2014/05/23/ssc-gives-a-graduation-speech/

These excerpts capture the gist of the “speech” that I want to retain.


What if education, as you understand it – public or private or charter schooling from age four or five all the way to university as young adults – is, on net, a waste of your time and money?

Addressing The Alleged Benefits

Benefit 1: The philosophical benefits of feeling connected to the beauty of mathematics, the passion of the humanities, the great historical traditions.

Testing the claim: Compare to a control group — the unschooled

“unschooling” movement, a group of parents who think school is oppressive and damaging. They tell the government they’re home-schooling their children but actually just let them do whatever they want. They may teach their kid something if the child wants to be taught, otherwise they will leave them pretty much alone.

And this is really hard to study, because they’re a highly self-selected group and there aren’t very many of them.

What do we know from the small sample?

    1. if you’d stayed out of public school and stayed home and played games and maybe asked your parents some questions, then by the time your friends were graduating twelfth grade, you would have the equivalent of an eleventh-grade education.
    2. Louis Benezet’s experiment: He decreed that in some of the schools in his district, there would be no math instruction until grade six. He found that within a year, these sixth graders had caught up with their peers in traditional schools, and furthermore that they were able to think much more logically about math problems – figure out what was going on rather than desperately trying to multiply and divide all the numbers in the problem by one another.math education before grade six is useless at best. And it’s hard to resist the urge to generalize to other subjects and children even older still.

Why is it so easy for the unschooled to keep up with their better-educated brethren? My guess is that it’s because very little learning goes on at school at all.

      • According to the general survey of knowledge among college students, 3.3% know who Euclid was, 7.6% know who wrote Canterbury, and a full 15% know what city the Parthenon’s in.
      • 36% of high school students know that an atom is bigger than an electron, rather than vice versa. But a full 59% of college students know the same. That’s a whole nine percent better than chance. On one of the most basic facts about the fundamental entities that make up everything in existence.

“But knowledge isn’t about names and dates!” No, but names and dates are the parts that are easy to measure, and it’s a pretty good bet that if you don’t know what city the Parthenon’s in you probably haven’t absorbed the full genius of the Greek architectural tradition. Anyone who’s never heard of Chaucer probably doesn’t have strong opinions on the classics of Middle English literature.

Benefit #2: The practical benefits of being able to get a job and afford nice things like food and shelter.

Testing the claim: Employment

About fifteen percent of you will be some variant of unemployed straight out of college. Another ten percent will find something part-time. And another forty or so percent will be underemployed, working as waiters or clerks or baristas or something else that uses zero percent of the knowledge you’ve worked so hard to accumulate.

As bad as you will have it, everyone who didn’t graduate college still has it much, much worse. All the economic indicators agree with the signs from the desolate wasteland that was once our industrial heartland: they are doomed. Their wages are not stagnating but actively declining

Testing the claim: More education

As bad as the job market is, staying in school looks worse. Economists warn that attending law school is the worst career decision you can make, so much so that newly graduated lawyers have nothing do to but sue law schools for not warning them against attending and established firms offer an Anything But Law School Scholarship to raise awareness of the problem. Doctors are so uniformly unhappy that they are committing suicide in record numbers and nine out of ten would warn young people against going into medicine. Graduate school has always been an iffy bet, but now the ratio of Ph. D applicants to open tenure track positions has hit triple digits, with the vast majority ending up as miserable adjunct professors who juggle multiple part time jobs and end up making as much as a Starbucks barista but without the health insurance.

We were counting the benefits of formal education. We did not do so well in trying to prove that it left you more knowledgeable, but it did seem like it had some practical value in getting you a little bit more money.

What of the costs of education?

Musing for society at large

Well, first about twenty thousand hours of your youth. That’s okay. You weren’t using that golden time of perfect health and halcyon memories when you had more true capacity for creativity and imagination and happiness than you ever will again anyway.

the financial side of it. At $11,000 average per pupil spending per year times thirteen years plus various preschool and college subsidies, the government spends $155,000 on the kindergarten-through-college education of the average American.

How about to each of the individual types?

To the one who says:

I am the 3.3%! I know who Euclid was and I understand the sublime beauty of geometry. I don’t think I would have been exposed to it, or had the grit to keep studying it, if I hadn’t been here surrounded by equally curious peers, under the instruction of enthusiastic professors.

  • to you my advice is: if you’ve sacrificed everything for knowledge, don’t forget that. When you are a paralegal in Brooklyn, and you get home from work, and you are very tired, and you want to curl up in front of the TV and watch reality shows until you are numb, remind yourself that you value knowledge above everything else, that you will seek intellectual beauty though the world perish, and read a book or something. Or take a class at a community college.

my education was worth it….because of the friends, I made here

  • my advice is similar: if you’ve sacrificed everything for friendship, don’t forget that. When you are a paralegal in Brooklyn, or a market analyst in Seattle, or God forbid an intern in Michigan, and you get home from work, and you are very tired, and you want to curl up in front of your computer and check Reddit, remind yourself of the friends you made here and give them a call. See how they’re doing. Write them a Christmas card, especially if it is December. Anything other than declaring friendship your supreme value and drifting out of touch.

my education was worth it…because of the connections I made

  • If you’ve sacrificed everything for ambition, be ambitious as hell. When you are a paralegal in Brooklyn or whatever, claw your way to the top, stay there, and use it to do something important. If you’ve sacrificed everything for ambition, don’t you dare stop at middle manager.

my education was worth it… because it helped me learn civic values, become a better person who is better able to help others.

  • If you’ve sacrificed everything to help others, don’t let it all end with donating a tenner to the OXFAM guy on the street now and then. Join Giving What We Can or go volunteer somewhere. If you’ve sacrificed everything for others, make sure others get something good out of the deal!

my education was worth it because formal education in the school system taught me how to think.

  • Sorry, one second, HAHAHAHAHAHHAHAAAHAHAHAHHHAAHAHA…I’m sorry. Ahem. To you my advice is, again, similar. If you’ve sacrificed everything to learn how to think, learn how to think. When someone says something you disagree with, before you dismiss a straw man it and call that person names and slap yourself five for your brilliant rebuttal, take a second to consider it fairly on its own terms. Go learn about biases and heuristics and how to avoid them. Read enough psychology and cognitive science to figure out why your claim might kind of inspire hysterical laughter from people even a little familiar with the field. Just don’t sacrifice everything to learn how to think and end up only rearranging your prejudices.

And To Those Us Who Feel Fleeced

Finally, some of you will say, wait a second, maybe my education wasn’t worth it. Or, maybe it was the best choice to make from within a bad paradigm, but I’m not content with that.

To you, I can offer a small amount of compensation. You have learned a very valuable lesson that you might not have been able to learn any other way. You have learned that the system is Not Your Friend. I use those last three words very consciously. People usually say “not your friend” as an understatement, a way of saying something is actively hostile. I don’t mean that.

The system is not your friend. The system is not your enemy. The system is a retarded giant throwing wads of $100 bills and books of rules in random directions while shouting “LOOK AT ME! I’M HELPING! I’M HELPING!” Sometimes by luck you catch a wad of cash, and you think the system loves you. Other times by misfortune you get hit in the gut with a rulebook, and you think the system hates you. But either one is giving the system too much credit.

To you I don’t have very much advice…if I knew how to fix the system, it’s a pretty good bet other people would know too and the system would already have been fixed. Maybe you, armed with a degree from the University of [mumble], will be the one to help figure it out.

On the other hand, someone a lot smarter than I am did have some advice for you. Poor Kurt Vonnegut never did get to give a real graduation speech, but one of his books has some advice targeted at another major life transition:

Hello babies. Welcome to Earth. It’s hot in the summer and cold in the winter. It’s round and wet and crowded. On the outside, babies, you’ve got a hundred years here. There’s only one rule that I know of, babies-“God damn it, you’ve got to be kind.”

I don’t know how to fix the system, but I am pretty sure that one of the ingredients is kindness.

I think of kindness not only as the moral virtue of volunteering at a soup kitchen or even of living your life to help as many other people as possible, but also as an epistemic virtue. Epistemic kindness is kind of like humility. Kindness to ideas you disagree with. Kindness to positions you want to dismiss as crazy and dismiss with insults and mockery. Kindness that breaks you out of your own arrogance, makes you realize the truth is more important than your own glorification, especially when there’s a lot at stake.

I Felt Bad For Picking My 3rd Grader Off

In trading, “picking someone off” means trading against a counterparty who would flake on the price they offered you if they knew what you know.

If I lift an offer on a TSLA March call option because I’m bullish, the market-maker on the other side of my trade doesn’t care. They would still sell me the call even if I texted them my rationale. But if I had the divine knowledge that Elon was going to tweet in the next 10 seconds that earnings would be reported in March not February, then I would be knowingly “picking off” the market-maker. As an options trader, you need to defend against pick-offs. You also want alerts if someone else is making a price that is not incorporating material, public info. For example, if an OPEC meeting date was moved there might be a tiny window when you could disguise a calendar spread as a routine roll when really you are trying to pick off the other side before they get the memo.

[In reality, when such news happens, market-makers will “sweep” all the resting customer orders with price limits below or above the option’s new fair value. It’s very difficult to pick off another professional who is consuming a real-time news feed.]

A few categories of pick-offs:

  • Pickoff trades related to changes in dates.

    If earnings are moved from early Feb to early March, then the “earnings volatility” needs to come out of the Feb expiry since you are no longer exposed to it, and the March options which now contain that volatility must appreciate relatively.

  • Pickoffs related to change in carry

    If a stock announces a change in its dividend that will affect the carry embedded in the options. If a dividend is slashed, the calls go up relative to the puts. Market makers need to be on top of how corporate actions affect the inputs into their pricing models.

  • Pickoffs related to changes in baskets

    If an ETF’s constituents change that affects vol of the underlying basket. If an ETF restricts creations, this can lead to the options and ETF becoming mispriced (one day I’ll tell the story of how this personally cost me 6 figures).

Pickoffs In Real Life

The tradition of trading floors is full of insane prop betting stories (NYMEX vets have so many to choose from but my personal favorite was watching one guy successfully pound 20 Coors Lites in an hour in one of the  upstairs offices).

But picking people off can be as easy as making bets with folks who are arithmetically challenged. Most people are. You only need to look up polls by @10kdiver to see that even professional investors, a subset of the population who should be able to compute a return, struggle numerically.

I am overstating the case a bit.

  1. I don’t know how many of those respondents are professional investors. I’d also admit there are times I’m impatient and just take a guess just to see the results. This is probably common behavior.
  2. When confronted with a bet, people’s defenses go up. They are wary of strangers bearing gifts and will assume there’s a catch.

Now that was a long-winded, but hopefully fun, introduction to a story that I will improve your numerical intuition and illuminate a lesson that is central to both investing and engineering problems.

The Proposition

My 3rd-grader came home with a packet of math worksheets from school. Two of the sheets, a total of 10 questions, were incomplete. He said the teacher didn’t require those sheets to be done.

What a bummer.

I thought they were the best questions from the whole packet. I asked him to solve the total of 10 questions but decided to make my request a little spicier. I offered him the following bet:

If you get them all correct, I will give you $5. Otherwise, you owe me $5.

He thought for a moment, then accepted. Before he went off to work on them, I started to wonder if my impulsive proposition was fair.

Is It A Fair Bet?

After eyeballing the questions, I estimated he had a 90% chance of getting any question correct. Another way to say that, is I expect he gets 1 wrong on average. Right off the bat,  I think I’m going to win. It’s not a fair bet.

This led me to compute a couple numbers.

  1. If my estimate of 90% hit rate per question is correct, what’s the chance he gets them all correct?

    .9010 = 35%

    That means he’s almost a 2-1 underdog

  2. What would his hit rate need to be per question to make the bet fair?

    First we need to convert what a fair bet means in math language. This is straightforward. Since it’s an even $5 bet then the fair proposition would not be, on average, he gets 1 wrong, but that he gets all the questions correct 50% of the time. 

    x10 = 50%

    x = .50 1/10

    x = 93.3%

    So if he had a 93.3% chance of getting any single question correct, then he has a 50% chance of winning the bet.

Flipping The Odds In His Favor

I’m not trying to take candy from a 3rd grader, I just wanted to make him more eager to do the questions. So, I tweaked the bet after he returned with the answers. Each of the 2 worksheets had 5 questions each. I decided to batch the bet as follows:

If he gets all the questions correct, he wins.

If he gets all the questions in one batch correct but not the other, it’s a push.

If he gets less than 100% on each batch then he loses the bet. 

How did this tweak alter the proposition?

In the first bet, if he got anything wrong, he lost. With these rules, he only loses if he gets, at least, one wrong in each batch.

We need to analyze all the possible outcomes that can occur with 2 batches.

First, we must ask:

What is the probability he gets all the questions right within a batch of 5 questions?

Assume he has a 90% hit rate again. 

.95 = 59%

So for either batch he has a 59% chance of getting a perfect score and a 41% chance of getting at least one wrong (ie a non-perfect score). 

Now we must consider all the possible outcomes of the proposition and their probabilities.

  1. Perfect score in both batches

    59% x 59% = 34.8%

  2. Perfect score in one batch but not the other

    59% x 41% = 24.2%

  3. At least one wrong in both batches

    41% x 41% = 16.8%

If we sum them all up we get 75.8%.

Wait, these don’t add to 100%, what gives??

We need to weigh these outcomes by the number of ways they can happen.

The possibilities with their probabilities are as follows:

  • Win, Win = 34.8%
  • Win, Lose = 24.2%
  • Lose, Win = 24.2%
  • Lose, Lose = 16.8%

Collapsing the individual possibilities into the proposition’s probabilities we get:

  • Win: 34.8%
  • Push: 48.4% (24.2% + 24.2%)
  • Lose: 16.8%

These probabilities sum to 100% and tell us:

  1. The most likely scenario of the bet is a push, no money exchanged
  2. Otherwise, he wins the bet 2x more than he loses the bet

This is a powerful result. Remember, his hit rate on any individual question was still 90%. By batching, we changed the proposition into a bad bet for him, into a good bet because he gets to diversify or quarantine the risk of a wrong answer.

Even More Diversification

With 2 batches we saw the range of possibilties conforms to the binomial distribution for n = 2:

p2 + 2p(1-p) + (1-p)2

where p = probability of perfect score on a batch

In English, the coefficients: 1 way to win both + 2 ways to push + 1 way to lose both

What if we split the proposition into 5 batches of 2 questions each?

These are the bet scenarios:

  1. Win =  5 pairs of questions correct
  2. Lose = at least one wrong in each of the 5 pairs to lose the bet
  3. Push = and any other combination (i.e. 3 perfect batches + 2 imperfect batches)

How do the batch outcomes roll up to the 3 bet scenarios?

  1. We must count how many ways there are to generate each of the scenarios.
  2. We must probability weight each way.

The summary table shows the work.

[Note the coefficients correspond to the coefficients for the binomial expansion (x+y)5 which is also the row of Pascal’s Triangle for N = 5]

Outcome Scenario # of ways to win probability weights Count x probabilities
5 wins (wins the bet scenario)  win combin(5,5) = 1 0.81⁵ = 34.9% 1 x 34.9% = 34.9%
4 wins, 1 loss (push) push combin(5,4)= 5 .81⁴ x .19 = 8.2% 5 x 8.2% = 41%
3 wins, 2 losses (push) push combin(5,3) = 10 .81³ x .19² = 1.9% 10 x 1.9% = 19%
2 wins, 3 losses (push) push combin(5,2) = 10 .81² x .19³ = .45% 10 x .45% = 4.5%
1 win, 4 losses (push) push combin(5,1) = 5 .81 x .19⁴ = .11% 5 x .11% = .55%
5 losses (lose the bet) lose combin(5,0) = 1 .19⁵ = .025% 1 x .025% = .025%
Total: 2⁵ = 32 100%

The net result of quarantining the questions into 5 groups of 2:

35% chance he wins the bet

65% chance he pushes on the bet

Nearly 0% chance he loses on the bet!

If you took this quarantining logic further and treated each question as its own bath then the new phrasing of the bet would be:

If he gets every question correct, he wins

If he gets every question incorrect, he loses

Any other scenario is a push

The corresponding probabilities:

Win = .910 = 35%

Lose = .110 = E-10 or 0%

So the benefits of separating the bets were mostly achieved above when we batched into groups 5 pairs of questions.

Conclusion

The first required my son to get a string of questions correct. Even though I estimated he had a 90% chance of getting any question correct, by making the net outcome dependent on each chain-link the odds of his success became highly contingent on the length of the chain.

With a chain length of 10, the bet was unfair to him. By changing the bet to be the result of success on smaller chains (the batches) I changed the distribution of outcome. It did not increase his chance of winning, but it reduced his chance of losing by creating offsetting scenarios or “pushes”. In other words, the smaller chains reduced his overall risk without sacrificing his odds of winning. It was a free lunch for him.

When you create long chains of dependency (ahem, positive correlations), an impurity in any link threatens your entire proposition. In these examples, we are dealing with binary outcomes. This is a trivial analysis. With investing, the distributions of the bets are not easily known.  It is well-known, however, that diversifying or not putting all your eggs in one basket is a free lunch. Still, if the investments are highly correlated, you may be fooling yourself and depending on a long chain.

Imagine if the 10 questions my son had were the type of word problem where the answer to each question is the input to the next. That’s a portfolio of highly correlated assets. If you are “yield-farming” crypto stablecoins you have probably thought about this problem. Spreading the risk across many coins can offset many idiosyncratic risks to the protocols. But is there a translucent, hard-to-see chain of correlation tying them all together that only reveals itself when the whole background goes black? That’s systemic risk. Ultimately, the only hedge to such a risk is position sizing at the aggregate level where you sum the gross positions. This is why stress-testing a portfolio to that standard is a quant’s “last level of defense”.

Jarvis, what happens to my portfolio when all correlations go to one?


[If you are in the investing world you will see parallels to this lesson in the ergodicity1 problem.]


Oh yea, how’d the bet with my 3rd grader go?

He got a perfect score on one batch of 5, and he got 1 wrong in the second batch. So the overall bet was a push, and his old man didn’t do so bad in estimating he’d have a 90% hit rate.


Selling Calls: It Might Be Passive, But It Ain’t Income

First something nice. An amuse-bouche:

That was pleasant enough.

Now violence.

You have heard of selling calls for “passive income”. The pitches which promote this idea are using the word “income” in the same sense that I would earn “income” if I sold you my house for $100. The income is a receipt or a cashflow, but this is just mechanical accounting. I have not earned income in any economic sense of the word. A receipt is not income without considering value given vs value received.

Suppose you own a $50 stock. Imagine you sold the $45 strike call for $5. Imagine the scenarios:

  • Stock goes up: Let’s say it goes to $60
    • $10 profit on stock holdings
    • Call option you are short goes up by $10
    • You are assigned on your call option, your stock is called away, leaving you with no position. P/L =0
  • Stock falls but remains above the strike: Let’s say it goes to $47
    • $3 loss on stock holdings
    • Call option you shorted falls to $2. You earn $3 on that leg.
    • Again, you are assigned on your call option, your stock is called away, leaving you with no position. P/L =0
  • Stock falls below the strike: Let’s say it goes to $40
    • $10 loss on stock holdings
    • Call option you shorted expires worthless. You earn $5 on that leg.
    • Since the call is worthless, you still own the stock and you have a net loss of $5

A few things to observe:

  1. You can only lose. This makes sense. You sold an option at its intrinsic value. Visually:
  2. These scenarios are exactly the same as if you held no stock position and you sold the 45 strike put at $0. This is called “put/call parity”.

    Parity means equal. It means a call is a put and a put is a call. Your stock position combined with the option you are long or short determines your effective position.

    • Long stock, short call = short put (this is all covered calls!)
    • Short stock, long call = long put
    • Long stock, long put = long call
    • Short stock, short put = short call

      You can prove this to yourself by making up more scenarios as I did above. Draw those hockey stick diagrams to summarize.

      So when you sell a call against your stock position, you are now saying “I prefer total downside and limited upside”.

  3. Is the call worth selling?

    Nobody says “I prefer total downside and limited upside”. But bond investors choose this all the time. Because the relevant question is about PRICE. Any proposition can be ruined or alluring depending on the price. An option’s price is simply a future state of the world discounted by its probability.

    When you sell an option, you don’t earn income. You just bet against some future state of the world. Whether this was a good idea or not depends on the price. Price is the market-implied odds. The actual odds are an imaginary idea. Price is a flesh-and-blood painting of the idea that you can interact with. Unless your day job is to figure out if the depiction of that idea, the price, is accurate, it’s best to assume it is.

    Suppose, instead of selling that 45 strike call for $5 you could sell it for $6. This parallel shifts the hockey stick $1.00 higher.

    This is a more attractive pay-off, but as a covered call writer, you need to ask yourself…is it attractive enough? Let me answer for you.

    You have no idea.

    What would you need to know to even evaluate the question “is it attractive enough”?

    You’d need to know something about the odds of the stock making an X% move by the expiration date. This is mostly what we mean when we say “volatility”. How will you know those odds? You can’t. You can only guess. And that’s what the price was in the first place. The wisdom-of-crowds guess. Do you have a reason to believe you can beat the line? What do see that option price-setters don’t?

    Professional volatility traders have an opinion as to what the fair value of the option is. If they sell an option for more than its alleged “fair value”, some internal accounting systems may allow them to book the excess premium as “income”. But they would call that “theoretical edge” or “theo”, not income. And even that edge is taken with truckloads of salt. 1

How To Respond To Your Advisor

If [insert “options as income” advisor] thinks you should sell calls ask them:

Is the option overpriced?

They won’t say no. They probably also won’t say yes, since how the hell do they know. They’ll say:

“You’ll be happy if the stock gets there.”

Sure you might be happy if the stock goes to your strike. But that’s cherry-picking the point of maximum happiness for any short option position. It’s literally, the short option position’s homerun scenario. Your broker is selling you on the best-case scenario. The remaining win vs lose scenarios are painfully asymmetric:

  • In a scenario where the stock goes up a lot, you are getting unboundedly sadder.
  • In the case where the stock goes down a lot (assuming you weren’t going to sell no matter what), you are better off by the amount of the premium you sold, which is capped.

Do not benchmark your opinion of the trade to stock-grind-up-to-my-short-strike scenario.

The Main Takeaways

  1. In the single stock game, you cannot afford to NOT get piggish results on the upside since most single stocks have awful long-term returns. You will be sad if you invest in securities with unlimited upside but systematically truncate that upside.
  2. Here’s a link to the document I wish I wrote. It’s highly intuitive. It does better than explain. It shows how you are incinerating money if you are selling calls below what they are worth even when you are “just overwriting”.


Final Word

It’s possible your advisor doesn’t totally grok the concept as laid out in QVR’s document or even what I wrote about. They have been bombarded with so much callsplainin’ that the discourse has been vocally one-sided. This post is probably in vain, but perhaps one RIA at a time, we can move past “selling options for income” as they internalize that:

  • The price of the option is central to the proposition.
  • Since what drives price is complex, any discussion about the attractiveness of overwriting becomes more nuanced.

As far as option promoters and authors who treat an entire premium as passive income? Clowns.

If I’m aggressive in saying that it’s because the overwriting fetish is so widespread, there’s nothing to do but make people feel bad about a naive, unsound practice that hinges on “you’ll be happy anyway, even if you lose”. That’s utter garbage. The difference between a winning poker player and a losing poker player might be a single big blind per hour. You cannot afford to just piss away expectancy.

So when you see these promoters you can safely dismiss them as charlatans. We need less of those these days.

You’re welcome for the very simple, reductionist negative screen. I just saved you many hours of brain damage, a trip to Orlando for that “Make $10k Per Week” options seminar, and the $899 “course materials” emblazoned with a pic of someone who probably looks like me2 with slicked-back hair in a rented Lambo. You can smell the Drakkar Noir from the glossy page.

Actual option traders don’t wear suits. And they don’t tell you to sell calls for income.

Moontower #128

Happy Thanksgiving weekend!

This week’s Money Angle will be interesting to anyone who fits any of these categories:

  1. Has a financial advisor
  2. Reads books with the words “passive income” or “financial freedom”
  3. Knows what an option is

Money Angle

First something nice. An amuse-bouche:

That was pleasant enough.

Now violence.

You have heard of selling calls for “passive income”. The pitches which promote this idea are using the word “income” in the same sense that I would earn “income” if I sold you my house for $100. The income is a receipt or a cashflow, but this is just mechanical accounting. I have not earned income in any economic sense of the word. A receipt is not income without considering value given vs value received.

Suppose you own a $50 stock. Imagine you sold the $45 strike call for $5. Imagine the scenarios:

  • Stock goes up: Let’s say it goes to $60
    • $10 profit on stock holdings
    • Call option you are short goes up by $10
    • You are assigned on your call option, your stock is called away, leaving you with no position. P/L =0
  • Stock falls but remains above the strike: Let’s say it goes to $47
    • $3 loss on stock holdings
    • Call option you shorted falls to $2. You earn $3 on that leg.
    • Again, you are assigned on your call option, your stock is called away, leaving you with no position. P/L =0
  • Stock falls below the strike: Let’s say it goes to $40
    • $10 loss on stock holdings
    • Call option you shorted expires worthless. You earn $5 on that leg.
    • Since the call is worthless, you still own the stock and you have a net loss of $5

A few things to observe:

  1. You can only lose. This makes sense. You sold an option at its intrinsic value. Visually:
  2. These scenarios are exactly the same as if you held no stock position and you sold the 45 strike put at $0. This is called “put/call parity”.

    Parity means equal. It means a call is a put and a put is a call. Your stock position combined with the option you are long or short determines your effective position.

    • Long stock, short call = short put (this is all covered calls!)
    • Short stock, long call = long put
    • Long stock, long put = long call
    • Short stock, short put = short call

      You can prove this to yourself by making up more scenarios as I did above. Draw those hockey stick diagrams to summarize.

      So when you sell a call against your stock position, you are now saying “I prefer total downside and limited upside”.

  3. Is the call worth selling?

    Nobody says “I prefer total downside and limited upside”. But bond investors choose this all the time. Because the relevant question is about PRICE. Any proposition can be ruined or alluring depending on the price. An option’s price is simply a future state of the world discounted by its probability.

    When you sell an option, you don’t earn income. You just bet against some future state of the world. Whether this was a good idea or not depends on the price. Price is the market-implied odds. The actual odds are an imaginary idea. Price is a flesh-and-blood painting of the idea that you can interact with. Unless your day job is to figure out if the depiction of that idea, the price, is accurate, it’s best to assume it is.

    Suppose, instead of selling that 45 strike call for $5 you could sell it for $6. This parallel shifts the hockey stick $1.00 higher.

    This is a more attractive pay-off, but as a covered call writer, you need to ask yourself…is it attractive enough? Let me answer for you.

    You have no idea.

    What would you need to know to even evaluate the question “is it attractive enough”?

    You’d need to know something about the odds of the stock making an X% move by the expiration date. This is mostly what we mean when we say “volatility”. How will you know those odds? You can’t. You can only guess. And that’s what the price was in the first place. The wisdom-of-crowds guess. Do you have a reason to believe you can beat the line? What do see that option price-setters don’t?

    Professional volatility traders have an opinion as to what the fair value of the option is. If they sell an option for more than its alleged “fair value”, some internal accounting systems may allow them to book the excess premium as “income”. But they would call that “theoretical edge” or “theo”, not income. And even that edge is taken with truckloads of salt. 1

How To Respond To Your Advisor

If [insert “options as income” advisor] thinks you should sell calls ask them:

Is the option overpriced?

They won’t say no. They probably also won’t say yes, since how the hell do they know. They’ll say:

“You’ll be happy if the stock gets there.”

Sure you might be happy if the stock goes to your strike. But that’s cherry-picking the point of maximum happiness for any short option position. It’s literally, the short option position’s homerun scenario. Your broker is selling you on the best-case scenario. The remaining win vs lose scenarios are painfully asymmetric:

  • In a scenario where the stock goes up a lot, you are getting unboundedly sadder.
  • In the case where the stock goes down a lot (assuming you weren’t going to sell no matter what), you are better off by the amount of the premium you sold, which is capped.

Do not benchmark your opinion of the trade to stock-grind-up-to-my-short-strike scenario.

The Main Takeaways

  1. In the single stock game, you cannot afford to NOT get piggish results on the upside since most single stocks have awful long-term returns. You will be sad if you invest in securities with unlimited upside but systematically truncate that upside.
  2. Here’s a link to the document I wish I wrote. It’s highly intuitive. It does better than explain. It shows how you are incinerating money if you are selling calls below what they are worth even when you are “just overwriting”.


Final Word

It’s possible your advisor doesn’t totally grok the concept as laid out in QVR’s document or even what I wrote about. They have been bombarded with so much callsplainin’ that the discourse has been vocally one-sided. This post is probably in vain, but perhaps one RIA at a time, we can move past “selling options for income” as they internalize that:

  • The price of the option is central to the proposition.
  • Since what drives price is complex, any discussion about the attractiveness of overwriting becomes more nuanced.

As far as option promoters and authors who treat an entire premium as passive income? Clowns.

If I’m aggressive in saying that it’s because the overwriting fetish is so widespread, there’s nothing to do but make people feel bad about a naive, unsound practice that hinges on “you’ll be happy anyway, even if you lose”. That’s utter garbage. The difference between a winning poker player and a losing poker player might be a single big blind per hour. You cannot afford to just piss away expectancy.

So when you see these promoters you can safely dismiss them as charlatans. We need less of those these days.

You’re welcome for the very simple, reductionist negative screen. I just saved you many hours of brain damage, a trip to Orlando for that “Make $10k Per Week” options seminar, and the $899 “course materials” emblazoned with a pic of someone who probably looks like me2 with slicked-back hair in a rented Lambo. You can smell the Drakkar Noir from the glossy page.

Actual option traders don’t wear suits. And they don’t tell you to sell calls for income.

Moontower #127

I’d normally stuff an investment idea in Money Angle but this will be useful to anyone that has $10,000 in a savings account earning nothing.

The current government rate on I-bonds is 7.12%. A quick rundown:

What is an I-bond?

A US savings bond issued by the Treasury intended to protect the owner from inflation.

How is the rate determined?

The rate is called a composite rate. It is comprised of a fixed rate plus a variable rate that is indexed to inflation. The variable rate is set every May and November based on the prior 6 months’ CPI-U index.

You can find the formula for the composite rate here, but the most important point is this:

The fixed-rate, currently 0%, acts as a floor. Even if CPI goes negative (as it did in the aftermath of the high 1970s inflation), you cannot earn less than 0% on the bond.

Is it taxable?

Only at the Federal level (so if you live in NJ, NY, IL or CA you should be buying these). You can report the interest on your tax form every year or you may defer it until you redeem the bond. Most people defer, but if your child owns it, you may prefer to claim the interest in the year it accrues. Details here.

If you use the proceeds for education, even the Federal tax can be avoided but there are many exceptions to this including income exclusions for high earners. Details here.

Are they liquid?

Unlike TIPs, these are not traded in the open market. When you buy them, they are associated with your social security number. If you want your cash back, you must redeem the bonds.

When can I redeem the bonds?

The bond matures in 30 years, but you cannot redeem them in the first year.

If you redeem a bond before it is 5 years old, you forgo the recent 3 months’ interest.

After 5 years, you may redeem with no penalty. Full details here.

Notice that if you bought these today at 7.12% interest, redeemed them in 1 year, and paid the 3-month interest penalty, you’d still be way better off than a CD or savings account, even in the worst-case.

To demonstrate that I’ll walk you through the math of buying $10,000 worth of bonds.

Nov 1: Buy $10,000 I-bonds

Nov 1- May 1, 2022: Accrue 3.56% interest. Accrued redemption value is $10,356.

Let’s also assume CPI-U magically drops to 0% for that time, resetting the I-bond variable rate to zero.

Nov 1, 2022: The bond has accrued no additional interest. You decide to redeem these stupid bonds, and forgo your last 3 months’ interest. Alas, there was no interest in the past 3-months, so there’s no penalty.

Net result: You earned 3.56% interest for 1-year and only pay Federal taxes on it. Still much better than a savings/CD account and no extra risk except liquidity.

Just for thoroughness, if the variable rate reset in May kept the rate the same at 3.56%, you’d get a compound result. You’d earn 3.56% on $10,356 of principal.

So what’s the catch?

There are a few.

  • You need a social security number.
  • You may only purchase up to $10,000 of them in a given year. (You can actually buy an additional $5,000 if you have a tax refund).
  • You need to spend 10 minutes creating a treasurydirect.gov account and remember that you have an asset there.

The upshot of all this

If the “catches” don’t bother you, this is free money.

There are other details such as how to buy them as gifts or for your children. You can explore that on your own here.

Money Angle

I have been catching up on all the web reading I didn’t do while traveling this summer. As I work through them, I usually read and discard. If it’s interesting, I might tweet about it. Sometimes the post applies to an idea I already plan to write about it, so I file it, and it makes its way into something I publish later. Here are a few that stood out that don’t necessarily fit into something I’m working on but are worth sharing broadly.

  • Radical Complexity (21 min read)
    Jean-Philippe Bouchaud

    This is a non-technical paper by one of Wall Street’s most widely regarded quants, addressing 6 topics. Thanks to @VolQuant for pointing it out.

    Abstract:

    This is an informal and sketchy review of six topical, somewhat unrelated subjects in quantitative finance: rough volatility models; random covariance matrix theory; copulas; crowded trades; high-frequency trading & market stability; and “radical complexity” & scenario-based (macro)economics. Some open questions and research directions are briefly discussed.

The next few posts tie together beautifully and work well in order. If read in the prescribed order, the vibe goes from theoretical to applied (and also less cynical which is a better way to end Moontower according to the shit sandwich method.)

  1. Bubble Wealth (3 min read)
    Prof. Bradford Cornell (h/t @choffstein)

    I like simple. The author uses a 3-person toy model to show how accounting works to link the snapshot of wealth in a system to the flows. There are 2 ideas I’d point your attention to.

    • The potential to construct a psychology compassThis is an idea I had while reading the post. One can study periods of major flows to handicap the distribution of realized vs unrealized p/l amongst an asset’s holders. This can hint at a system’s bias towards fear or greed.

      If that intrigues you, check out the first half of Lyn Alden’s How Market Capitalization Works And A Look At Rolling Bubbles (19 min read).


      For professionals, you will recognize that this reasoning is similar to the difference between money-weighted and time-weighted returns.

      My friend Aneet Chachra recently wrote a post that uses creation/redemption data for ETFs to infer money-weighted returns.

      See ETFs Are The New Stocks — Mind The Creation/Redemption Gap (4 min read)

    • An asset’s “convenience yield” (a term borrowed from backwardated futures markets)From the paper:

      In the example, Coin provides absolutely no services, but in reality, Coin could be a substitute means of exchange providing a convenience yield.

      Whatever the reason that trading starts, if the price begins to rise then in a world of incomplete information and heterogeneous beliefs, the price increase could become self-fulling in a manner such as that originally described by Harrison and Kreps (1978). Although a pure example of Coin might not exist in the real world, some actual securities such as cryptocurrencies like Bitcoin or stocks such as Nikola, AMC, and GameStop can be thought of as portfolios consisting of a combination of a security that has rights to future consumption and Coin. The Coin part of the portfolio would function just like pure Coin did in the example and have all the same effects.


      If that intrigues you, check out Lily Francus’ On Memes, Dreams, and Currencies (15 min read).

  2. Why the Bezzle Matters to the Economy (15 min read)
    Michael Pettis

    Try to count how many times you nod while you read just the intro:


    In a famous passage from his book The Great Crash 1929, John Kenneth Galbraith introduced the term bezzle, an important concept that should be far better known among economists than it is. The word is derived from embezzlement, which Galbraith called “the most interesting of crimes.” As he observed:

    Alone among the various forms of larceny [embezzlement] has a time parameter. Weeks, months or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in—or more precisely not in—the country’s business and banks.

    Certain periods, Galbraith further noted, are conducive to the creation of bezzle, and at particular times this inflated sense of value is more likely to be unleashed, giving it a systematic quality…

  3. Apes, Rocks & the Future of Finance (14 min read)
    Dave Nadig

    Excerpt from the conclusion:

    I’m actually super bullish non-Crypto and NFTs and particularly, the kind of tokenized asset management being done in the DeFi space…But here’s the thing: it’s also OK to miss it. I believe the Crypto sandbox is going to revolutionize how we move value around the global economy in countless ways, the same way the internet revolutionized how we move information around the global brain. But big, big global change happens much more slowly than technology itself.

    I welcome Dave’s unique voice in the crypto conversation. With a strong understanding of traditional finance and an open mind bordering on “techno-optimism” (a term often used pessimistically), Dave is critical without being dismissive.

    This is a smart, balanced post. Especially if you are weary of how polarizing crypto and DeFi can feel.

    And as a former floor trader, the expression “exchange seat capitalism” could not convey a dynamic any more succinctly. Wish I would have thought of that myself.

I-Bonds For You

This will be useful to anyone that has $10,000 in a savings account earning nothing.

The current government rate on I-bonds is 7.12%. A quick rundown:

What is an I-bond?

A US savings bond issued by the Treasury intended to protect the owner from inflation.

How is the rate determined?

The rate is called a composite rate. It is comprised of a fixed rate plus a variable rate that is indexed to inflation. The variable rate is set every May and November based on the prior 6 months’ CPI-U index.

You can find the formula for the composite rate here, but the most important point is this:

The fixed-rate, currently 0%, acts as a floor. Even if CPI goes negative (as it did in the aftermath of the high 1970s inflation), you cannot earn less than 0% on the bond.

Is it taxable?

Only at the Federal level (so if you live in NJ, NY, IL or CA you should be buying these). You can report the interest on your tax form every year or you may defer it until you redeem the bond. Most people defer, but if your child owns it, you may prefer to claim the interest in the year it accrues. Details here.

If you use the proceeds for education, even the Federal tax can be avoided but there are many exceptions to this including income exclusions for high earners. Details here.

Are they liquid?

Unlike TIPs, these are not traded in the open market. When you buy them, they are associated with your social security number. If you want your cash back, you must redeem the bonds.

When can I redeem the bonds?

The bond matures in 30 years, but you cannot redeem them in the first year.

If you redeem a bond before it is 5 years old, you forgo the recent 3 months’ interest.

After 5 years, you may redeem with no penalty. Full details here.

Notice that if you bought these today at 7.12% interest, redeemed them in 1 year, and paid the 3-month interest penalty, you’d still be way better off than a CD or savings account, even in the worst-case.

To demonstrate that I’ll walk you through the math of buying $10,000 worth of bonds.

Nov 1: Buy $10,000 I-bonds

Nov 1- May 1, 2022: Accrue 3.56% interest. Accrued redemption value is $10,356.

Let’s also assume CPI-U magically drops to 0% for that time, resetting the I-bond variable rate to zero.

Nov 1, 2022: The bond has accrued no additional interest. You decide to redeem these stupid bonds, and forgo your last 3 months’ interest. Alas, there was no interest in the past 3-months, so there’s no penalty.

Net result: You earned 3.56% interest for 1-year and only pay Federal taxes on it. Still much better than a savings/CD account and no extra risk except liquidity.

Just for thoroughness, if the variable rate reset in May kept the rate the same at 3.56%, you’d get a compound result. You’d earn 3.56% on $10,356 of principal.

So what’s the catch?

There are a few.

  • You need a social security number.
  • You may only purchase up to $10,000 of them in a given year. (You can actually buy an additional $5,000 if you have a tax refund).
  • You need to spend 10 minutes creating a treasurydirect.gov account and remember that you have an asset there.

The upshot of all this

If the “catches” don’t bother you, this is free money.

There are other details such as how to buy them as gifts or for your children. You can explore that on your own here.

Moontower #126

I often share articles about career management. Interviewing, negotiation, what to study, and so on. Some of my writing is me thinking aloud about my own career. But when I’m asked directly for general career advice, I got nothing of my own. It’s impossible to not let your own experience have a tyrannical influence on what you say, so the advice I give could literally be the opposite of what’s right for you. A tension I see with all advice is whether the outcome was “because of” or “in spite of”. (I probably triggered some people by using video games as an example of this)

So recently, when I was asked for advice, I queried the hive and noted the common advice. The context was quant/trading but there were broad prescriptions as well.

I refactored it to make evergreen and cleaner. As an assurance, even though some of these accounts are anonymous, they are professionals.

Before the details let’s see the common themes.

Everyone Agrees These Are Important

  • Emphasis on aptitude (often proxied by pedigree) & teachability over direct market knowledge Although if you lack any market knowledge you might struggle convincing an interviewer on the next point…
  • A genuine interest: The game is hard, you will need persistence and interest to carry you through the inevitable difficulties. You should be able to demonstrate this.
  • Skills. In today’s marketplace, you must have technical skills. Math and coding. While that’s a common theme below, I’ll give 2 additional reasons for needing these skills. The first — as an assistant, the more useful you can be to your bosses the faster you’ll progress. Training apprentices is expensive in time and money. It’s not great if you have to spend company time learning broad skills. You put yourself at a disadvantage. Secondly, skills allow you to self-start. You can prototype and test. If you need to rely on a dev or quant to study hypotheses that are probably wrong in the first place, you are dead in the water. You need to be able to build yourself so you can iterate through ideas faster.

Check out the rest of the document here:

https://notion.moontowermeta.com/career-advice

It includes:

  • Advice from specific accounts
  • Broader advice from outside the trading world. Some controversial.
  • A link to my own career musings

Money Angle

Using Insurance For Tax-Free Investment Growth

I recently did some work to understand permanent insurance. Collective eye roll. I’m with you. I begrudge Peter Thiel for forcing me to do this.

My annoyance is your gain. I documented what I’ve learned about permanent and private placement life insurance. Here’s an excerpt from the conclusion:

Insurance is not a fun topic. I’m more of markets guy not a Marty-Bird-structuring-type-of-guy. It makes my head hurt. The layers of fuzzy risks plus costs present many trade-offs. Overall, it felt worthwhile to consolidate and organize my notes from reading and phone calls into this post.

continue reading:

Using Insurance For Tax-Free Investment Growth (14 min read)

From My Actual Life

My buddy Paul was living in Taiwan recently. We had a call one night to talk about career stuff (which for me is just mid-life crisis therapy). Paul does these regularly because his work is focused on thinking about how we work. He has done tons of research, spoken to hundreds of people, and given a lot of thought to life paths. Despite an MIT degree and success out the gate in the consulting world, he pulled the ripcord on a trajectory that would make most parents proud.

Paul asked if we could turn the camera on for the chat. Sure why not.

You can find the convo here. Paul’s insights and story will get you thinking. I might get you thinking if you can get past how slow I can speak. I recommend 1.5x speed because the thought of you seeing me at 1x speed makes me not want to get outta bed ever again.

[In his weekly letter, Paul highlighted the 11 points he found resonant. Check it out and sub to his terrific Substack here]

Using Insurance For Tax-Free Investment Growth

It’s broadly expected that income and capital gains taxes will increase, especially for high earners. It’s a waste of time to speculate on the specifics but Matthew Hague has a handy summary of the largest proposed changes. If you are a high-earner in CA or NYC, you’re looking at all-in income taxes well north of 50% as well as an increase in capital gains taxes. Naturally, you want to know what tools are available to minimize the tax burden. In this post, I will relay what I have learned about insurance as a tool for allowing investment returns to compound tax-free.

I’ll start with a caveat. You should be skeptical.

A common impression of insurance companies, is they sell you coverage that you often never use and have no idea if they will find fine print to weasel their way out of paying out benefits. The salespeople are cringe. The industry is huge and a poster-child for regulatory capture, beholden to powerful lobbyists. And even despite the heavy regulation, a bunch of bumbling Michael Scott-types found their way to the front page of the WSJ during the GFC when they fancied themselves option traders (via CDS).

I’m with you. I have lots of doubts about insurance. When someone tries to pitch you on permanent (ie whole-life) insurance it’s best to tell them to beat it. You are perfectly capable of “buying term and investing the difference”. But something I cannot dismiss, is that there are wealthy, financially sophisticated investors with large insurance policies. Then a loved one, also an investor, who was also dismissive of insurance started digging. So much so that he got a license to structure policies for his family as well as his 3 siblings’ families commission-free. Combine all this with 2 interesting developments in the tax and insurance world, and it was time to start calling people in my network to help me learn.

This post is a summary of my discoveries. I’m not a tax/insurance pro, so I disclaim everything. I wanted to get everything down on paper both for my own reference and for any readers that are interested in taking the baton. Insurance has hard-to-value trade-offs. But if you have substantial savings, it is worth learning more. This post is what I know so far.

Reviewing Basic Tax Hygiene

There are simple, well-established practices for allowing your investments to compound tax-free.

  • Use tax-advantaged accounts to hold interest-bearing or dividend-paying investments (ie IRAs, 401ks, 529s)
  • Focus on after-tax returns. Private investments that trade frequently generate short-term gains. Active mutual funds will also. ETFs allow you to decide when you sell, so you can shift your decision to a “long term” gain where tax rates can be significantly lower than ordinary rates.
  • Borrowing against large portfolios to fund spending, to avoid triggering capital gains. This is a standard playbook for rich insiders who are confident in their company’s prospects and don’t want to interrupt compounding with cap gains. If you have a large diversified portfolio on a platform like Interactive Brokers, you can use portfolio margining to borrow at attractive rates without needing to liquidate holdings. This is a form of leverage, which comes with its risks you need to evaluate.
  • The real kicker to the borrowing method is that when you pass away, your holdings receive a “stepped-up” basis essentially crystallizing a lower overall tax burden for your heirs.

While the tax code is about to get more fluid (potentially threatening stepped-up basis and rules around loans collateralized by stock holdings) until now these techniques have been standard.

The use of permanent insurance has also been well-understood. However, compared to the techniques listed above, it incurs more brain damage, expense, opacity, and coordination (often involving agents, advisors, and lawyers and especially when trusts are come into play). The good news (or bad news, depending on your perspective) is that you wouldn’t bother exploring this unless you have enough assets to make it worthwhile. My goal is to provide enough context, so you can even have a hint as to whether it might be worthwhile.

Insurance As A Tax-Advantaged Account

The way life insurance works is you pay annual premiums in exchange for a tax-free death benefit when you pass. If you die suddenly, the insurance company takes a bad beat. You may have paid a small amount of premium and received a big benefit. If you live to 100, you likely abandoned your policy at some point because it became to expensive or you just didn’t need it anymore and the underwriter keeps your premiums. The actuaries balance this risk/reward. With term insurance, this is all straightforward. It’s like buying a put option on your life with a fixed premium for a fixed expiration date. You must naturally pay a premium over the actuarial odds, but insurance is a competitive industry so you can expect they are reasonable. If your family’s life with be financially wrecked by the loss of your income, you should insure against that.

Permanent insurance combines term insurance with a savings vehicle. Investopedia explains:

Unlike term life insurance, which promises payment of a specified death benefit for a specific period of years, permanent life insurance lasts the lifetime of the insured (hence, the name), unless nonpayment of premiums causes the policy to lapse. Permanent life insurance premiums go toward both maintaining the policy’s death benefit and allowing the policy to build cash value. The policy owner can borrow funds against that cash value or, in some instances, withdraw cash from it outright to help meet needs such as paying for a child’s college education or covering medical expenses.

There is often a waiting period after the purchase of a permanent life policy during which borrowing against the savings portion is not permitted. This allows sufficient cash to accumulate in the fund. If the amount of the total unpaid interest on a loan, plus the outstanding loan balance exceeds the amount of a policy’s cash value, the insurance policy and all coverage will terminate.

Permanent life insurance policies enjoy favorable tax treatment. The growth of the cash value is generally on a tax-deferred basis, meaning that the policyholder pays no taxes on any earnings as long as the policy remains active.

As long as certain premium limits are adhered to, money can also be taken out of the policy without being subject to taxes because policy loans usually are not considered taxable income. Generally, withdrawals up to the sum total of premiums paid can be taken without being taxed.

Because of the savings vehicle embedded in permanent insurance, the premiums are higher, but much of that premium belongs to the policyholder and accrues to the cash value of the policy. That excess premium can be invested for tax-free growth.

The basic identity:

Cash Value = Premiums + Returns – Costs

Permanent insurance usually falls in one of these categories:

  1. whole life: the excess premium are invested in low-risk fixed income instruments for a more predictable return
  2. variable life: the premiums are invested in mutual funds
  3. indexed-life: the returns are tied to the performance of an index but protected from loss (like a structured product which uses option collars. The fund overwrites call options to finance the purchase of puts)

These policies have a bad rap for good reasons.

  • They have expensive commissions, often front-loaded, meaning that your cash value will lag the premiums invested for several years before catching up. You are immediately underwater, and if you wanted to stop paying premiums, you have incinerated the money.
  • You are taking the insurance company’s credit risk.
  • The investment options are more limited than the full menu you might find at any large broker.

Again the sensible advice for most people is “buy term, invest the difference”. But let’s see why your situation might warrant a closer look.

First, we need to back up a few decades.

The History Of A Very Consumer-Friendly Policy (Loophole?)

Permanent insurance is a strange Frankenstein. Many public investment products, especially the type offered by an insurance company, are commoditized, unbundled, and subject to highly competitive fee pressures. Why would you want to then bundle an investment with your term insurance? It goes back to the taxes. Remember, the policies grow and payout tax-free. Of course, everyone understands this. It’s the crux of the slimy broker’s pitch. Insurance products are hard to price and evaluate, so the agent has lots of room to structure a policy that maximizes the underwriter’s profit or may simply be unsuitable for the client (the worst case, is a common case — the policy is too large and the client eventually throws in the towel on the premiums, causing the product to lapse before it accumulates).

So if you want to properly take advantage of the IRS’s tax-free growth loophole, you need to understand how to structure a consumer-friendly policy. The key to this is to construct the policy from the outset so it is built for accumulation and minimizes the actuarial insurance cost. Remember, you are not interested in the life insurance portion of this product. You are trying to stuff as much money into the policy to grow tax-free. Like sticking an unlimited amount of savings into a Roth IRA.

Wealthy people understood this idea 50 years ago. In the 1980’s, rich investors were overfunding policies by egregious amounts. So they might have a $5mm death benefit which would might incur annual premiums on the order of $5k or $10k but they might stuff hundred of thousands of dollars into it. Finally, the IRS wisened up and passed the Technical and Miscellaneous Revenue Act of 1988 (TAMRA). This act changed the landscape by creating Modified Endowment Contracts or MECs. A heavily overfunded  would be considered a MEC and lose much of its advantaged tax status.

Here’s Investopedia:

This act created the MEC. Before this law was passed, all withdrawals from any cash-value insurance policy were taxed on a first-in-first-out (FIFO) basis. This meant the original contributions that constituted a tax-free return of principal were withdrawn before any of the earnings. But TAMRA placed limits on the amount of premium that a policy owner could pay into the policy and still receive FIFO tax treatment. Any policy that receives premiums in excess of these limits automatically becomes a MEC.

Suddenly, these super consumer-friendly tax loopholes did not make sense for investors who wanted to access the cash during their lifetimes. The death benefit still allows the holder to pass the proceeds tax-free to their heirs, but with penalties and taxes associated with loans and withdrawals, these policies only make sense for the ultra-rich without liquidity needs.

The Non-MEC Policy

MEC rules work by limiting how much you can stuff into a policy for a given level of death benefit.1. Don’t hold me to make-belive numbers, but to be allowed to stuff $5mm of premiums into a policy, to not trigger MEC designation, you might need to purchase a policy with a $20mm death benefit. The actuarial cost of that life insurance, eats into your investment returns.

The key to structuring a consumer-friendly policy that avoids MEC designation. Remember, if the policy is treated as a MEC then you cannot withdraw or borrow against the policy tax-free because you lose FIFO tax treatment. So you want to start with how much premium you want to invest in this tax-free structure then find the minimum amount of death benefit you need to buy to make sure the policy doesn’t classify as MEC.

The IRS uses a “corridor rule” to determine that the death benefit is high enough for a given level of premiums to ensure that the policy still looks like an insurance contract and not simply a stealth Roth.

Investopedia again:

There must be a “corridor” of difference in dollar value between the death benefit and the cash value of the policy.

Private Placement Life Insurance Expands Your Investment Options

There are many types of mutual funds and annuities permanent insurance policies can invest in. But if you prefer to hold private investments in an insurance wrapper you will need to look at private placement life insurance or PPLI. Before explaining how PPLI works, I’ll start with why I wanted to learn about it in the first place.

Why PPLI Could Be Worth Exploring 

In continuing my theme of skepticm regarding insurance as an investment, I will say that PPLI is even less relevant to most people. Still, my own interest in it was prompted by 2 developments, one of which is now moot, but it’s still worth discussing.

  1. IRAs disallowing private investments

    The recent tax proposal seeks to limit wealthy individuals from using tax-advantaged accounts to avoid paying Uncle Sam (thanks Peter Thiel for pulling the ladder up on the regular 1-percenters… everyone else can put their tiny violins away now). The proposal would ban any investment requiring “accreditation” from being custodianed in an IRA.2

    If you have private investments that are trading-oriented and generate short term cap gains, you would need to divest them from your IRA. Many of these investments live on the lower absolute return/higher Sharpe’s spectrum so paying taxes annually on the gains would be make them significantly less attractive. PPLI offers a tax-advantaged way to hold them.

    (As of October 28th, the revised proposal has since slashed this restriction. The proposal will continue to require earlier RMDs or required minimum distributions for IRAs with over $10mm in assets can theoretically still make PPLI a workaround for those people. again, we are getting to even smaller numbers of people who are going to care about this.)

  2. The amount of premium you can put into these policies for a given level of death benefit has doubled

    In December 2020, the IRS lowered the interest rate assumptions used in the construction of permanent insurance. This means you do not need to buy as much of a death benefit for a given level premium. The “corridor” has narrowed. If you used to need to buy a $40mm death benefit to invest $5mm in PPLI, now you only need to buy $20mm death benefit for that same $5mm of investment. This lower the actuarial cost of insurance over the life of the contract.

With PPLI seeming like the only viable way to hold high turnover strategies and the cost of maintaining a policyy falling, I looked into what they can actually hold.

Investment Options Within PPLI

PPLI policies allow 2 main channels to invest.

  1. IDFs and VITs

    Insurance policies cannot directly invest in mutual funds or private funds. The management of such funds needs to create another entity to accept insurance feeders. If the fund is public, this can be done via a VIT or variable insurance trust. I just think of them as a share class that accepts funds from insurance policies. The analog on the private side is IDFs or insurance dedicated funds. For example, your insurance policy can invest in Millenium’s IDF. Izzy Englander’s fund is a good example of a fund that makes sense for a tax-advantaged entity because its annual gains are going to be treated as short-term profits.

    Be aware:
      • To access VITs or IDFs the platform you subscribe to PPLI with needs to onboard them
      • IRC Sec 817(h) is a diversification mandate which effectively require you to hold 5 investments

  2. Advisor mediation

    If you want to choose investments that are not available via IDFs or VITs then an advisor must make the selections for you on a discretionary basis. While your investment statement define criteria for their choices, you cannot directly instruct the advisor’s choices. Lack of agency here is a drawback.

[If you run an investment fund you should take note. Any increase in tax rates makes PPLI more attractive on the margin. I expect assets held by insurance policies will grow. If you are a GP of a fund with many retail, especially HNW, investors it’s probably a good idea to explore creating a VIT or IDF feeder for your fund.]


While PPLI still maintains the above restrictions on what can be invested in, the menu is growing and the primary advantage over conventional permanent insurance structures is access to private investments.

Costs

The good news is you can access directly PPLI platforms directly, there’s no broker or insurance middleman.  But this process isn’t cheap. In addition to a couple thousand bucks for the health exams, you can easily rack up $20k in attorney fees to setup the structures depending on how complicated your estate is.

Then there are the costs directly associated witht he policies. There fall in two categories. One-time costs based on premium invested and ongiong maintenance costs. Let’s break these down.

  1. One-time premium-based expenses

    • DAC or “deferred acquisition charges”

      This is a flat 1% federal tax on the premium put into the policy. It’s like a one-time goverment load.

    • Premium tax

      This is a state tax on the premium amount. Most are between 1.75%-2.5%. South Dakota has one of the lowest premium tax rates if you hold the policy in a trust or LLC (2% on the first $100k, .08% on everything else). 

  2. Ongoing expenses

    • Mortality and Expense fee

      You can think of this like an AUM fee. It’s about 40 bps annually based on the cash value of the policy.

    • COI or cost of insurance

      This is the actuarial premium paid for the death benefit you receive. This is about 15-20 bps annually for a healthy individual. 


To think about the fees over the life of the contract you can spread the premium based fees over the life of the contract. If you are 40 and live to 80 the premium-based fee add little drag since you are dividing say 2% over 40 years, and that is only on the initial invested premium not the growth. 

When you model out, both sets of fees you see in the insurance proposals, it ends up costing you about 70bps per year. Is 70 bps good or bad? 

First of all, that is 70 bps in addition to the expenses or fees charged by the underlying funds. But assuming your comparing to private funds you would have invested in via a non-tax-advantaged account, that is a wash.  So whether the 70 bps is a good deal depends on your returns. If you earn 8% gross, but would have paid 300 to 400 bps in taxes annually, than 70 bps is a good deal. If the gross CAGR of your investments is only 3%, than you are not saving much. So you can think of the 70 bps as a hurdle to be compared with the tax drag of the counterfactual portfolio. 

Evaluating that 70bps is downstream of soul-searching you should be doing anyway, “Are these private investment options worth it?

Not For Everyone

Between the costs and consideration of pros/cons of illiquid private investments in the first place, it’s pretty clear PPLI is only worth exploring if you checked yes at every node of the gauntlet. While most PPLI policies are non-MEC (indicating that the holders expect to either drawdown or borrow against the policy’s cash value in their lifetime), there is still a significant proportion that is MEC. This suggests that many holders are families who never expect to need these millions of dollars and preffered the flexibility to allocate substantial sums to a policy quickly, violating tests that would permit non-MEC status.

While I laid out the basics above, in reality, the holders of such policies are combining them with trusts to preserve generational wealth. Platform minimums are about $2mm (for a non-MEC policy imagine a household funding $500k/yr for 4 years corresponding to say a $20mm deah benefit). But the typical policy holder is probably stuffing away more like $5mm-$10mm and has a net worth in the tens of millions.

Wrapping Up


My little dive into insurance topics was driven by:

  • the specter of higher taxes. I live in CA so my family gets smoked on taxes as it is.
  • the threat of changes that would have required us to divest funds requiring accreditation from our self-directed IRAs. Many of those investments, are not tax-efficient so holding them outside a tax-advantaged structure would force us to reconsider the allocations entirely.
  • the realization that my friends who run funds should consider whether they should have IDF or VIT feeders

Insurance is not a fun topic. I’m more of markets guy not a Marty-Bird-structuring-type-of-guy. It makes my head hurt. The layers of fuzzy risks plus costs present many trade-offs. Overall, it felt worthwhile to consolidate and organize my notes from reading and phone calls into this post.

Again, this topic is outside my wheelhouse, so if I’ve made errors or you have questions, please reach out. We are learning in public together.