hedging is for gardeners

Let’s start with this YouTube/Podcast episode where Erik and I discuss hedging.

📺Delta Hedging Cost Benefit Analysis | The Options Trench

  • What hedging is: reducing or isolating risks you do not want, to maximize exposure to ones you intend to get paid on
  • The difference between direct hedges and correlated, indirect hedges with basis risk.
  • Why every hedge has a cost, including premiums, bid-ask spreads, commissions, slippage, and opportunity cost.
  • Why you will almost always have “ragrets”: if the hedge works, you wish you hedged more; if it does not, you regret paying for it.
  • How protective puts, put spreads, collars, and covered calls change risk and cost.
  • The tradeoff between cheaper short-dated protection and more expensive long-dated protection.
  • How rising stock prices can make an old put hedge less effective by increasing your unprotected “deductible.”
  • Two ways to manage hedges: rebalance on a fixed schedule or act when risk crosses a predetermined band.
  • How hedges can preserve capital and buying power during market stress, when the best opportunities may appear.
  • An introduction to delta hedging, active delta management, gamma scalping, and how these concepts apply to options strategies.

I noticed this tweet a few weeks ago and it reminded me an example of my training days back in my AMEX days with SIG.

You had full discretion to delta hedge against the option orders you’d do. But as you learn in the podcast, hedging is a cost. You don’t want to hedge if the risk is tolerable. “Hedging is for gardeners.”

SIG had a big balance sheet and very tolerant of letting deltas ride so the bias to hedge was to hedge only if you thought the option order was “smart”. For example, if a cust has a pattern of selling puts right before the stock price rips higher, you want to hedge aggressively when you buy the puts. In fact, you might want to “overhedge.” Instead of buying the amount of shares prescribed by the delta you hedge “1-to-1” or “1 up” meaning you buy 100 deltas worth, effectively turning the put into synthetic calls.

Fast forward to 2026:

This is conceptually similar to our point above about how rising stock prices can make an old put hedge less effective by increasing your unprotected “deductible.” You need to roll the position if your exposure strays sufficiently far from the one you intend to have on. In this case, jbulltard who wants to be short puts wants to be shorter more substantial puts than the 60 strike so he “rolled up” either to re-strike his delta or vol position (or both).

In training, we discussed a scenario which the tweet reminded me of, but in the opposite direction. The question posed by an instructor was:

Imagine a customer coming in to roll his or her put down. They will need to sell a put spread as they close the higher strike and buy the lower one. If you are a market-maker providing liquidity to the seller by buying the put spread to hedge, you buy the stock.

Hold it right there.

If this customer is taking a profit by selling the higher strike put and opening a long position in the lower strike, they are actually still bearish. This customer that has been correct is not covering their short. Technically, they are less short than they were before rolling, but the roll is to get more option firepower in the next leg down. Think of the intent.

As a market-maker, you don’t want to hedge when you buy this put spread. The customer has given you the position you want. You’re short deltas, betting on the same side as the smart customer!

The option flow service above seems like it correctly identified that the trade was a put spread, but it presented the trade as someone buying the put spread. Technically, someone did buy it since there’s a buyer and seller on every trade, but the presumption when you say someone bought the spread is that a customer or “paper” bought the spread, not the market-maker.

Slop/Counterslop

As of 7/21, Substack has a Pangram integration to scan for how much of a post is written by AI.

You can use it on the web from the Substack inbox. Click on a post, hit the 3 dots:

And voila:

Well done David.

Pangram is capable of false positives, but I ran it on both posts I published this week and it was accurate. One was 100% human and one it said 20% AI and 8% AI-assisted which sounds about right (my Thursday post included synopsis bullet points from my Scale notes).

I subscribe to 140 substacks. I don’t miss a word of about 5% of them. Another 10% there’s a decent chance I’ll read, and then there’s a steep falloff. Many of these emails have instrumental value that is going unmined.

[I should probably unsubscribe to the ones I ignore, but I’m not an inbox zero guy. Gmail search is solid and with the Claude-Gmail connector being an email bloodhound, organizing mail is a waste of time.]

I have scheduled jobs that “read” every distribution I’m on. One of my side projects is operationalizing this intake to get value out of this material (I’m into another phase of this which I’ll write about eventually). Running the Panagram scanner on a sample of the emails I read this week…well, let’s just say a lot of what’s out here is 100% AI-generated. I don’t agree that 100% AI means slop since I see posts from insightful people who I don’t think would write at all if it meant a lot more work than massaging a robot to wordsmith your thoughts. I wouldn’t call them writers, but I might still want the info. I actually think they should lean into their non-writer-but-have-something-to share-status. Dump your prompt in the post and move on. If the AI can write your post, my AI can read it. I don’t need you to bother. I don’t want to read it if I can’t feel anything, and I cannot feel anything from what a robot wrote.

Adam Mastroianni explained it well:

Words themselves don’t contain feelings—they are a recipe for creating that feeling inside your own head, to assemble the right set of emotions out of the experiences you have at hand. If I do a good job, the subjective experience that results inside you might resemble the one that originated inside me, but it will never be identical, because we’re working with different ingredients.

The computer doesn’t know any of this. It can’t know any of this. It can only read the cookbook; it can’t taste the meal. Objective knowledge can make your sentences true, but it can’t make them alive.

If it’s not obvious, only people who care about writing itself as an act of expression will be left writing without AI. Writing will be seen as an act of arrogance. A sense that your point-of-view is worth transmitting personally because the unique way it travels is itself part of the message. I will be clinging to self-importance thank you very much.

In Socrates 2026, I had this non-sequitur:

Injecting a thought

AI cannot motivate you. It cannot inspire you. AI offers an unbundling of the tutor, not a replacement. The role of humans in the learning loop is going to grow, which might be a contrarian position. Think of coaches. Some are exceptional because they are masters of the Xs and Os. Some are exceptional because of their ability to lead and communicate. These are squishy. The squishy things will not rise in relative importance. They are important and AI doesn’t change that either way. It’s that AI will put a spotlight on the fact that there will be relatively higher yields to focus on the squishy. Whether we will or not (and be able to judge the delta) is an open question. A topic for another day perhaps, but I’m betting on this with my time.

I spent over an hour walking through the local hills while talking to ChatGPT’s voice functionality Thursday evening. It was the easiest way to think through a large automation project. I won’t discuss the project yet but the sense I had while architecting it with ChatGPT was a new one. It was the feeling I know some friends had about 8 months ago and a smaller group of people (but not a tiny group) had 18 months ago and so on. A tiny group had the feeling a decade ago.

I suspect one’s appreciation for the feeling would be correlated to whatever innate ability one would have for chess even if they never played chess. I know I couldn’t have had the feeling much earlier. I just can’t see enough steps ahead. I can only fathom a little bit of abstraction before my mind begs for a physical demonstration of possibility.

The feeling is that much of what you do is nothing but a loop. Once you see the loop well enough to label its parts, you lose something. Mystery. There’s just less mystery about routine. I wouldn’t have thought anything we called “routine” had mystery in the first place, until that was the thing I felt disappeared. I admit, losing some mystery cost a sense of ego. And yet that feeling was totally overwhelmed by a different mystery. The one the techies and rationalist types have been going on about. “What’s coming next?”

We just finished watching the Mandalorian series. I know, I know. The kids were not interested years ago, so we tried again. In the final season, there’s a utopian city run by Jack Black and Lizzo that is captive to the droids who serve it. Automation has led to Brave New World levels of learned, almost embraced, helplessness. They get bailed out by Din Djarin and Bo-Katan Kryze, which undermines the society’s cautionary tale potential, but alas, Disney. Instead, the city is held up as a UBI-paradise where citizens are freed from scarcity to indulge their passions.

I personally don’t believe UBI can be sold to Americans en masse unless it is imposed from the kind of authoritarian control that we have thus far resisted. Thus far. We’re supposed to be the pole that rejects the social credit score for safety bargain. Our culture (again, thus far) is imprinted with the knowledge that UBI is incoherent because our spirits are blind to whether competition is for physical or positional scarcity. We know better than to “exchange a walk-on part in the war for a lead role in a cage?”

If we are not on our knees, UBI may come anyway but in disguise. TBTF equity markets, voluntarily scrolling ourselves into the Matrix, or whatever the grade inflation version of employment is, financed by literal inflation.

I only say these things to acknowledge the singularity backdrop of anything pertaining to our industrial future. I am not dismissing them. I have no clue what’s coming. But my feeling is I won’t recognize the way I worked for much of my adult life in the same way that a recent grad would not recognize the White Pages (yes, there used to be a list of landlines alphabetized by last name for everyone in your town).

I don’t feel a sense of doom but a feeling that technology will free us from the least human parts of our work. If you wonder how, it ties back to the beginning of this 100% organic post. The world we’re heading into will elevate reading because what will remain of human writing, the writing that is actually read by humans, will have no reason to exist other than its humanity.

That metaphor will apply everywhere.

I’m hopeful that we will look back at the past 10-20 years as the terrible twos of a connected world. A transition marked by phone-neck and expectations running ahead of reality. But if our anxiety is peaking just before reality gets significantly better, that would make perfect sense.

Every generation believes it lives in interesting times. It sure beats apathy.

Counterslop

Peter Yang shared his “No AI slop” skill which you can just tell your LLM to ingest.

https://github.com/petergyang/no-ai-slop/blob/main/SKILL.md

Major Ralph and Sam checking into work energy:

Moontower #322

In this issue:

  • Slop. Counterslop.
  • What are retail option traders up to?
  • Hedging is for gardeners

Friends,

As of 7/21, Substack has a Pangram integration to scan for how much of a post is written by AI.

You can use it on the web from the Substack inbox. Click on a post, hit the 3 dots:

And voila:

Well done David.

Pangram is capable of false positives, but I ran it on both posts I published this week and it was accurate. One was 100% human and one it said 20% AI and 8% AI-assisted which sounds about right (my Thursday post included synopsis bullet points from my Scale notes).

I subscribe to 140 substacks. I don’t miss a word of about 5% of them. Another 10% there’s a decent chance I’ll read, and then there’s a steep falloff. Many of these emails have instrumental value that is going unmined.

[I should probably unsubscribe to the ones I ignore, but I’m not an inbox zero guy. Gmail search is solid and with the Claude-Gmail connector being an email bloodhound, organizing mail is a waste of time.]

I have scheduled jobs that “read” every distribution I’m on. One of my side projects is operationalizing this intake to get value out of this material (I’m into another phase of this which I’ll write about eventually). Running the Panagram scanner on a sample of the emails I read this week…well, let’s just say a lot of what’s out here is 100% AI-generated. I don’t agree that 100% AI means slop since I see posts from insightful people who I don’t think would write at all if it meant a lot more work than massaging a robot to wordsmith your thoughts. I wouldn’t call them writers, but I might still want the info. I actually think they should lean into their non-writer-but-have-something-to share-status. Dump your prompt in the post and move on. If the AI can write your post, my AI can read it. I don’t need you to bother. I don’t want to read it if I can’t feel anything, and I cannot feel anything from what a robot wrote.

Adam Mastroianni explained it well:

Words themselves don’t contain feelings—they are a recipe for creating that feeling inside your own head, to assemble the right set of emotions out of the experiences you have at hand. If I do a good job, the subjective experience that results inside you might resemble the one that originated inside me, but it will never be identical, because we’re working with different ingredients.

The computer doesn’t know any of this. It can’t know any of this. It can only read the cookbook; it can’t taste the meal. Objective knowledge can make your sentences true, but it can’t make them alive.

If it’s not obvious, only people who care about writing itself as an act of expression will be left writing without AI. Writing will be seen as an act of arrogance. A sense that your point-of-view is worth transmitting personally because the unique way it travels is itself part of the message. I will be clinging to self-importance thank you very much.

In Socrates 2026, I had this non-sequitur:

Injecting a thought

AI cannot motivate you. It cannot inspire you. AI offers an unbundling of the tutor, not a replacement. The role of humans in the learning loop is going to grow, which might be a contrarian position. Think of coaches. Some are exceptional because they are masters of the Xs and Os. Some are exceptional because of their ability to lead and communicate. These are squishy. The squishy things will not rise in relative importance. They are important and AI doesn’t change that either way. It’s that AI will put a spotlight on the fact that there will be relatively higher yields to focus on the squishy. Whether we will or not (and be able to judge the delta) is an open question. A topic for another day perhaps, but I’m betting on this with my time.

I spent over an hour walking through the local hills while talking to ChatGPT’s voice functionality Thursday evening. It was the easiest way to think through a large automation project. I won’t discuss the project yet but the sense I had while architecting it with ChatGPT was a new one. It was the feeling I know some friends had about 8 months ago and a smaller group of people (but not a tiny group) had 18 months ago and so on. A tiny group had the feeling a decade ago.

I suspect one’s appreciation for the feeling would be correlated to whatever innate ability one would have for chess even if they never played chess. I know I couldn’t have had the feeling much earlier. I just can’t see enough steps ahead. I can only fathom a little bit of abstraction before my mind begs for a physical demonstration of possibility.

The feeling is that much of what you do is nothing but a loop. Once you see the loop well enough to label its parts, you lose something. Mystery. There’s just less mystery about routine. I wouldn’t have thought anything we called “routine” had mystery in the first place, until that was the thing I felt disappeared. I admit, losing some mystery cost a sense of ego. And yet that feeling was totally overwhelmed by a different mystery. The one the techies and rationalist types have been going on about. “What’s coming next?”

We just finished watching the Mandalorian series. I know, I know. The kids were not interested years ago, so we tried again. In the final season, there’s a utopian city run by Jack Black and Lizzo that is captive to the droids who serve it. Automation has led to Brave New World levels of learned, almost embraced, helplessness. They get bailed out by Din Djarin and Bo-Katan Kryze, which undermines the society’s cautionary tale potential, but alas, Disney. Instead, the city is held up as a UBI-paradise where citizens are freed from scarcity to indulge their passions.

I personally don’t believe UBI can be sold to Americans en masse unless it is imposed from the kind of authoritarian control that we have thus far resisted. Thus far. We’re supposed to be the pole that rejects the social credit score for safety bargain. Our culture (again, thus far) is imprinted with the knowledge that UBI is incoherent because our spirits are blind to whether competition is for physical or positional scarcity. We know better than to “exchange a walk-on part in the war for a lead role in a cage?”

If we are not on our knees, UBI may come anyway but in disguise. TBTF equity markets, voluntarily scrolling ourselves into the Matrix, or whatever the grade inflation version of employment is, financed by literal inflation.

I only say these things to acknowledge the singularity backdrop of anything pertaining to our industrial future. I am not dismissing them. I have no clue what’s coming. But my feeling is I won’t recognize the way I worked for much of my adult life in the same way that a recent grad would not recognize the White Pages (yes, there used to be a list of landlines alphabetized by last name for everyone in your town).

I don’t feel a sense of doom but a feeling that technology will free us from the least human parts of our work. If you wonder how, it ties back to the beginning of this 100% organic post. The world we’re heading into will elevate reading because what will remain of human writing, the writing that is actually read by humans, will have no reason to exist other than its humanity.

That metaphor will apply everywhere.

I’m hopeful that we will look back at the past 10-20 years as the terrible twos of a connected world. A transition marked by phone-neck and expectations running ahead of reality. But if our anxiety is peaking just before reality gets significantly better, that would make perfect sense.

Every generation believes it lives in interesting times. It sure beats apathy.

Counterslop

Peter Yang shared his “No AI slop” skill which you can just tell your LLM to ingest.

https://github.com/petergyang/no-ai-slop/blob/main/SKILL.md

Major Ralph and Sam checking into work energy:

Money Angle

Here’s an example of a post that could have been 100% AI written and it would still be useful. I ran it through Pangram’s web app and it’s 100% human.

The Market Impact of Retail Options Trading | Nam Nguyen Ph.D.

The letter summarizes and links to 3 papers. The points below are the ones I found most interesting.

“Retail Trading in Options and the Rise of the Big Three Wholesalers”

Authors: Bryzgalova, Pavlova & Sikorskaya. Last revised Sep 2023.

  • Developed a novel measure of retail options activity using transaction-level data and new regulatory reporting requirements.
  • Validated the measure by showing it drops sharply during brokerage outages and trading restrictions.
  • Retail traders strongly prefer cheap, weekly options.
  • Those options carry very wide bid-ask spreads — averaging around 12% — making them costly to trade.
  • Many retail investors fail to exercise call options optimally before ex-dividend dates.
  • Retail trading now accounts for over 60% of total U.S. options volume.
  • Nearly 90% of payment-for-order-flow revenue comes from just three wholesalers.

“Retail Option Traders and the Implied Volatility Surface”

Authors: Eaton, Green, Roseman & Wu

  • Retail activity concentrates in short-dated, out-of-the-money call options.
  • Retail investors are typically net sellers of long-dated options.
  • Used 82 brokerage outages (2019–2021) as natural experiments to isolate retail trading effects. During outages, buying volume falls for retail-favored contracts but rises for long-dated options.
  • Implied volatility declines during outages for short-dated/OTM calls, but rises for long-dated options.
  • Retail demand affects not just the level of implied volatility but also the term structure, moneyness curve, and call-put spread of the entire IV surface.
  • Effects held up under robustness checks, ruling out a few heavily-traded options or dataset choice as the driver.

Quant Radio Podcast segment (this is an AI-generated podcast)

  • The classic signal “high option-to-stock volume = informed institutional trading” has broken down since 2020 as retail flow now dominates volume.

Money Angle For Masochists

Let’s start with this YouTube/Podcast episode where Erik and I discuss hedging.

📺Delta Hedging Cost Benefit Analysis | The Options Trench

  • What hedging is: reducing or isolating risks you do not want, to maximize exposure to ones you intend to get paid on
  • The difference between direct hedges and correlated, indirect hedges with basis risk.
  • Why every hedge has a cost, including premiums, bid-ask spreads, commissions, slippage, and opportunity cost.
  • Why you will almost always have “ragrets”: if the hedge works, you wish you hedged more; if it does not, you regret paying for it.
  • How protective puts, put spreads, collars, and covered calls change risk and cost.
  • The tradeoff between cheaper short-dated protection and more expensive long-dated protection.
  • How rising stock prices can make an old put hedge less effective by increasing your unprotected “deductible.”
  • Two ways to manage hedges: rebalance on a fixed schedule or act when risk crosses a predetermined band.
  • How hedges can preserve capital and buying power during market stress, when the best opportunities may appear.
  • An introduction to delta hedging, active delta management, gamma scalping, and how these concepts apply to options strategies.

I noticed this tweet a few weeks ago and it reminded me an example of my training days back in my AMEX days with SIG.

You had full discretion to delta hedge against the option orders you’d do. But as you learn in the podcast, hedging is a cost. You don’t want to hedge if the risk is tolerable. “Hedging is for gardeners.”

SIG had a big balance sheet and very tolerant of letting deltas ride so the bias to hedge was to hedge only if you thought the option order was “smart”. For example, if a cust has a pattern of selling puts right before the stock price rips higher, you want to hedge aggressively when you buy the puts. In fact, you might want to “overhedge.” Instead of buying the amount of shares prescribed by the delta you hedge “1-to-1” or “1 up” meaning you buy 100 deltas worth, effectively turning the put into synthetic calls.

Fast forward to 2026:

This is conceptually similar to our point above about how rising stock prices can make an old put hedge less effective by increasing your unprotected “deductible.” You need to roll the position if your exposure strays sufficiently far from the one you intend to have on. In this case, jbulltard who wants to be short puts wants to be shorter more substantial puts than the 60 strike so he “rolled up” either to re-strike his delta or vol position (or both).

In training, we discussed a scenario which the tweet reminded me of, but in the opposite direction. The question posed by an instructor was:

Imagine a customer coming in to roll his or her put down. They will need to sell a put spread as they close the higher strike and buy the lower one. If you are a market-maker providing liquidity to the seller by buying the put spread to hedge, you buy the stock.

Hold it right there.

If this customer is taking a profit by selling the higher strike put and opening a long position in the lower strike, they are actually still bearish. This customer that has been correct is not covering their short. Technically, they are less short than they were before rolling, but the roll is to get more option firepower in the next leg down. Think of the intent.

As a market-maker, you don’t want to hedge when you buy this put spread. The customer has given you the position you want. You’re short deltas, betting on the same side as the smart customer!

The option flow service above seems like it correctly identified that the trade was a put spread, but it presented the trade as someone buying the put spread. Technically, someone did buy it since there’s a buyer and seller on every trade, but the presumption when you say someone bought the spread is that a customer or “paper” bought the spread, not the market-maker.

From My Actual Life

It’s hard to believe, but we have 2 weeks before school starts again. You get some depressingly small number of summers with your kids in the grand scheme of things and they’re just too short. We’re trying to pack it in. We saw The Odyssey this past week and Ed Sheeran last night at Levi’s. Our 13-year-old couldn’t come. He was living the Boys of Summer song…

His friend’s birthday was this weekend so the dad took this crew to Lake Tahoe. He sent us this picture to the parent chat yesterday morning. Yinh and I were in immediate sync. “One of the best photos we’ve ever seen”.

There’s no future and no past in that shot. It’s pure presence with your friends.

I’m going to get it framed today to give to the birthday boy when they return.

 

 

Stay groovy

☮️

Moontower Weekly Recap

become an option mixologist

To piggyback off David Epstein’s explanation of chunking, I’ve discussed the technique several times in my writing in the context of options. I use the chess player’s word for it (although I’m not a chess player): dissection.

These articles give concrete examples:

The second one links to a video where you can follow along on an example.

At first, you consciously look for groups or patterns that compress a theme, but with practice this becomes automatic. You can’t help but see the pattern.

Like the sports examples, an experienced trader will be able to pull the trigger faster than slavish processing would allow. The shortcuts become part of their wiring. You could see this in an open outcry trading pit or even amongst the best mock trading students back in the old floor days. That ability to say “sold” or “buy’em” faster than a large group of competitive traders because you saw the arb line up is happening at a subconcious pattern level. You make the trade and working out the particulars of the “why” while the instructor is still in the act of halting the the class to ask why you made the trade. I don’t know how it works but my pop science guess is that your synapses which have been strenghtened along specific pathways are a step ahead of your explicit reasoning.

Dissection is a deliberate form of “chunking”. But if we zoom out a ring from the specifics of option structures to the parameters they express, there are only 3 we generally care about: volatility (or variance), skew, kurtosis. In stats terms, these map to the 2nd, 3rd, and 4th statistical moments of the distribution.

There’s a vanna-vega-volga model sometimes referred to as “the cost of gammas” framework which actually formalizes this idea by mapping the parameters to their costs.

Volatility is represented by the cost of the straddle.

Skew is represented by the cost of a risk reversal.

Kurtosis is represented by the cost of a strangle.

These map to pertinent Greeks as well:

straddle → gamma

RR → vanna

strangle → volga

You pay IV premiums for all of these convexities. Vol risk premia for the straddle, you pay skew premiums for the ability to be long spot-vol correlation in the direction for which IV tends to rise as the market moves (so in SPY you pay a premium for the puts but in oil today you pay a premium for the calls), and finally, for volga, or “vol gamma” you pay an IV premium for wingy options.

To a beginner, the zoo of option structures is overwhelming. Seriously look at this page, the screenshot is only part of what I could capture:

It doesn’t even cover them all. There’s still jelly rolls, Christmas trees, rev/cons, diagonals, strips, “stupids”. I’m not kidding on that last one (it’s buying or selling a package of options in the same maturity but different strikes, so buying both the 700 and 650 puts as opposed to spreading them).

But if you understand that there are only 3 parameters we care about, then all of this collapses into a few themes. There’s a million different types of cocktails, but according to the mixologists at Death & Co there’s just key elements to the drink:

  1. alcohol (base)
  2. sugar (sweetener)
  3. acid (brightener)

If you prefer the cooking analogy, it’s salt, fat, acid, heat.

All recipes, whether in options, cuisine, music (there are thousands of chords but you can collapse to major/minor modified by dominant, sus, and add9) can be reduced to a few themes.

How does this help?

I’ll give you an example from our Discord this week.

Someone asked:

Anyone got any ideas for screening for good call spreads or put spreads to buy systematically in a potentially semi-automated way using moontower. A lot of the guidance I’ve read is ‘if you have a directional view’… well umm, I’m a ding dong with no directional ideas want something algorithmic.

I’m also a ding-dong, I just happen to understand that the price of option structures derives from the cost of our 3 friends: volatility, skew, and kurtosis.

This was my response:

What makes a vertical or debit spread generally cheap?

Low IV and high skew at the strike you are selling. So relatively cheap ATM/.25d call spread will have low IV and high call skew.

A relatively cheap OTM call spread could come from the IV being relatively low and the .25d call skew being low if that’s the long leg of the spread.

So here are a few suggestions…

  1. Sort for low IV percentile and high call skew for ATM to .25d call spreads or
  2. Sort for low IV percentile and low call skew if you want to buy an OTM call spread, meaning your buy leg is say .25d
  3. Use our Trade Ideas tab to look at names that score well on “Buy Vol” and then also sort by call skew in the table below!

You can also talk to the agent about building a prompt for this and then make it an Automation.

Our Trade Ideas algo scores names based on how they stack up to various preset trade themes (ie “buy vol”, “sell vol”, “long calendar”) according to their parameters and what signatures we look for. You simply add the column for 25d call skew which tells you the percentile, and using the logic from my answer, find names where the parameters present attractive spreads.

You had to understand that the price of the option structures map to these 3 themes in the first place and suddenly the zoo of possible option trades is massively reduced in dimensionality. It’s the progression from option bartender at your college party to option mixologist where you understand that all drinks are just a few flavors.

And just to address the Automations thing, we have a new feature in our tool. An example of one of mine where the agent emails me on a schedule when a name with a strong “Buy Vol” score’s strike vols are down and vice versa:

How I Teach Middle Schoolers To Build Stock Portfolios

If you construct a portfolio from 2 stocks and one is $100 and the other is $10, buying a share of each means the first will dominate your portfolio’s risk, assuming they have the same volatility.

If you have $100,000 to invest, you can balance the risk by equal-weighting the holdings: $50k into each stock. You buy 500 shares of A and 5,000 shares of B.

But what if they aren’t the same volatility?

Equal-weighting means the most volatile stocks determine performance. If your $100,000 is split equally between the 2 stocks and A moves 10% per day while B moves 1% per day, you aren’t diversified. Stock A will mostly determine your returns.

We can achieve more balance via equal-risk-weighting, which adjusts how many dollars go into each stock based on its volatility.

Weight each stock by 1/vol:

  • Stock A gets 1/10
  • Stock B gets 1/1.

Divide by the total (1/10 + 1 = 1.1) and you get about 9% in A and 91% in B. Stock A is 10x as risky, so it gets about 1/10th the dollars.

On $100,000 that’s roughly $9k of A and $91k of B, corresponding to

  • 91 shares of A
  • 9,100 shares of B

Compared to the equal-dollar portfolio, the equal-risk portfolio requires you’d sell about 409 shares of A and buy about 4,100 shares of B, moving roughly 41% of your total portfolio value from the jumpy stock to the calm one.

No masochism for the kids but in case you’re interested…

Equal risk weighting is the starting point for so-called risk parity weighting. The difference is that instead of only considering the volatility a holding adds to the portfolio, the correlation is considered. A stock highly correlated with the rest of your portfolio contributes a lot of risk, while an anti-correlated one does a better job diversifying and reducing total portfolio risk. The effect can be so strong that even a highly volatile but anti-correlated stock can reduce total risk.

Computing a correlation-aware risk contribution requires a full covariance matrix and an optimizer — i.e., a guess-and-test calculator — to find the portfolio weights, since there’s no closed-form solution. If the kids can grok equal vol-weighting I feel like I’ve done my job, and they can discover risk parity on their own if they’re so inclined.)

Your own Portfolio HQ Spreadsheet

This workbook is designed to organize and monitor your first portfolio.

⏬ Download

The sheet is view-only. Select “duplicate” from the file menu to get your own copy.

In this video, I show you how to use the sheet and talk about the Investment “lab” we did this week.

Moontower #321

In this issue:

  • Experts make decisions faster than they can process. How?
  • How I teach middle-schoolers to build stock portfolios
  • The zoo of option structures masks the simplicity

Friends,

I didn’t know that author David Epstein (Range, The Sports Gene, Inside The Box) had a YouTube channel until I watched this awesome video.

The hook is timely and well-constructed. It starts by litanying just how ridiculous Messi plus a puzzle…Messi walks for over 90% of the game. What is he doing?

David breaks down the cog-sci idea of “chunking” and how it relates to domain expertise. He offers 3 concepts to keep in mind as you build skills in your chosen lane.

It’s a well-done 15-min video. I was watching it at breakfast with my 13-year-old and 3 10-year-olds (post sleepover), and they were glued to the screen. It comes to life with examples not just from soccer (the Ronaldo thing is nuts), but baseball, boxing, chess, and football. My favorite demo was the one David made to animate what it’s like to be a quarterback that Drew Brees once gave in a talk.

Money Angle

If you construct a portfolio from 2 stocks and one is $100 and the other is $10, buying a share of each means the first will dominate your portfolio’s risk, assuming they have the same volatility.

If you have $100,000 to invest, you can balance the risk by equal-weighting the holdings: $50k into each stock. You buy 500 shares of A and 5,000 shares of B.

But what if they aren’t the same volatility?

Equal-weighting means the most volatile stocks determine performance. If your $100,000 is split equally between the 2 stocks and A moves 10% per day while B moves 1% per day, you aren’t diversified. Stock A will mostly determine your returns.

We can achieve more balance via equal-risk-weighting, which adjusts how many dollars go into each stock based on its volatility.

Weight each stock by 1/vol:

  • Stock A gets 1/10
  • Stock B gets 1/1.

Divide by the total (1/10 + 1 = 1.1) and you get about 9% in A and 91% in B. Stock A is 10x as risky, so it gets about 1/10th the dollars.

On $100,000 that’s roughly $9k of A and $91k of B, corresponding to

  • 91 shares of A
  • 9,100 shares of B

Compared to the equal-dollar portfolio, the equal-risk portfolio requires you’d sell about 409 shares of A and buy about 4,100 shares of B, moving roughly 41% of your total portfolio value from the jumpy stock to the calm one.

No masochism for the kids but in case you’re interested…

Equal risk weighting is the starting point for so-called risk parity weighting. The difference is that instead of only considering the volatility a holding adds to the portfolio, the correlation is considered. A stock highly correlated with the rest of your portfolio contributes a lot of risk, while an anti-correlated one does a better job diversifying and reducing total portfolio risk. The effect can be so strong that even a highly volatile but anti-correlated stock can reduce total risk.

Computing a correlation-aware risk contribution requires a full covariance matrix and an optimizer — i.e., a guess-and-test calculator — to find the portfolio weights, since there’s no closed-form solution. If the kids can grok equal vol-weighting I feel like I’ve done my job, and they can discover risk parity on their own if they’re so inclined.)

Your own Portfolio HQ Spreadsheet

This workbook is designed to organize and monitor your first portfolio.

⏬ Download

The sheet is view-only. Select “duplicate” from the file menu to get your own copy.

In this video, I show you how to use the sheet and talk about the Investment “lab” we did this week.

Money Angle For Masochists

To piggyback off David Epstein’s explanation of chunking, I’ve discussed the technique several times in my writing in the context of options. I use the chess player’s word for it (although I’m not a chess player): dissection.

These articles give concrete examples:

The second one links to a video where you can follow along on an example.

At first, you consciously look for groups or patterns that compress a theme, but with practice this becomes automatic. You can’t help but see the pattern.

Like the sports examples, an experienced trader will be able to pull the trigger faster than slavish processing would allow. The shortcuts become part of their wiring. You could see this in an open outcry trading pit or even amongst the best mock trading students back in the old floor days. That ability to say “sold” or “buy’em” faster than a large group of competitive traders because you saw the arb line up is happening at a subconcious pattern level. You make the trade and working out the particulars of the “why” while the instructor is still in the act of halting the the class to ask why you made the trade. I don’t know how it works but my pop science guess is that your synapses which have been strenghtened along specific pathways are a step ahead of your explicit reasoning.

Dissection is a deliberate form of “chunking”. But if we zoom out a ring from the specifics of option structures to the parameters they express, there are only 3 we generally care about: volatility (or variance), skew, kurtosis. In stats terms, these map to the 2nd, 3rd, and 4th statistical moments of the distribution.

There’s a vanna-vega-volga model sometimes referred to as “the cost of gammas” framework which actually formalizes this idea by mapping the parameters to their costs.

Volatility is represented by the cost of the straddle.

Skew is represented by the cost of a risk reversal.

Kurtosis is represented by the cost of a strangle.

These map to pertinent Greeks as well:

straddle → vega

RR → vanna

strangle → volga

You pay IV premiums for all of these convexities. Vol risk premia for the straddle, you pay skew premiums for the ability to be long spot-vol correlation in the direction for which IV tends to rise as the market moves (so in SPY you pay a premium for the puts but in oil today you pay a premium for the calls), and finally, for volga, or “vol gamma” you pay an IV premium for wingy options.

To a beginner, the zoo of option structures is overwhelming. Seriously look at this page, the screenshot is only part of what I could capture:

It doesn’t even cover them all. There’s still jelly rolls, Christmas trees, rev/cons, diagonals, strips, “stupids”. I’m not kidding on that last one (it’s buying or selling a package of options in the same maturity but different strikes, so buying both the 700 and 650 puts as opposed to spreading them).

But if you understand that there are only 3 parameters we care about, then all of this collapses into a few themes. There’s a million different types of cocktails, but according to the mixologists at Death & Co there’s just key elements to the drink:

  1. alcohol (base)
  2. sugar (sweetener)
  3. acid (brightener)

If you prefer the cooking analogy, it’s salt, fat, acid, heat.

All recipes, whether in options, cuisine, music (there are thousands of chords but you can collapse to major/minor modified by dominant, sus, and add9) can be reduced to a few themes.

How does this help?

I’ll give you an example from our Discord this week.

Someone asked:

Anyone got any ideas for screening for good call spreads or put spreads to buy systematically in a potentially semi-automated way using moontower. A lot of the guidance I’ve read is ‘if you have a directional view’… well umm, I’m a ding dong with no directional ideas want something algorithmic.

I’m also a ding-dong, I just happen to understand that the price of option structures derives from the cost of our 3 friends: volatility, skew, and kurtosis.

This was my response:

What makes a vertical or debit spread generally cheap?

Low IV and high skew at the strike you are selling. So relatively cheap ATM/.25d call spread will have low IV and high call skew.

A relatively cheap OTM call spread could come from the IV being relatively low and the .25d call skew being low if that’s the long leg of the spread.

So here are a few suggestions…

  1. Sort for low IV percentile and high call skew for ATM to .25d call spreads or
  2. Sort for low IV percentile and low call skew if you want to buy an OTM call spread, meaning your buy leg is say .25d
  3. Use our Trade Ideas tab to look at names that score well on “Buy Vol” and then also sort by call skew in the table below!

You can also talk to the agent about building a prompt for this and then make it an Automation.

Our Trade Ideas algo scores names based on how they stack up to various preset trade themes (ie “buy vol”, “sell vol”, “long calendar”) according to their parameters and what signatures we look for. You simply add the column for 25d call skew which tells you the percentile, and using the logic from my answer, find names where the parameters present attractive spreads.

You had to understand that the price of the option structures map to these 3 themes in the first place and suddenly the zoo of possible option trades is massively reduced in dimensionality. It’s the progression from option bartender at your college party to option mixologist where you understand that all drinks are just a few flavors.

And just to address the Automations thing, we have a new feature in our tool. An example of one of mine where the agent emails me on a schedule when a name with a strong “Buy Vol” score’s strike vols are down and vice versa:

From My Actual Life

The CA side of our family has a summer tradition called Cousins Camp that started 6 years ago.

This is the first time it’s not a full week as the scheduling gods are not cooperating. We stuffed into this weekend from Friday morning through Sunday.

It’s 8 kids ranging from age 10 to 16 (the eldest drives now!)

 

The “make a magazine” idea stems from our household love for Oyla. I made a short thread about it here:

 

Some people would call these the dog days of summer, but they are my favorite days. Even though you sometimes want to break it up with A/C…we’re doing a matinee with the kids to see Odyssey in 70mm IMAX this week. We don’t go to the movies often so this has the right summer throwback energy.

 

Stay groovy

☮️

Moontower Weekly Recap

the iron butterfly

I think about what Matthew Clifford said about technology when he was on Infinite Loops back in 2022 and before ChatGPT was a household name. Carved from my notes:

Matt Clifford: …modernity, however you want to define that…is about constant or apparently constant, apparently unstoppable motion towards the reduction of variance in our lives…for most of, let’s say, the second half of the 20th century post Second World War, anyone who lived in, for one of a better term, the west, had a life of far less variance than say 3, 4, 5, 10 generations before that. You could call that the triumph of modernity.

…if you look at what the 20th century was about from the perspective of work and ambition, it was really about having these more or less formalized tracks for ambitious people to climb.

And then something happened in the midst of these fantastic variance dampening institutions, we somewhat accidentally unleashed the mother of all variance amplifying institutions, and it’s called the Internet. And what the Internet does, is it selects the weird and amplifies it.

One slightly provocative framing would be that the rise of modernity, the rise of variance dampening institutions was really bad for ambitious people. It was really good for the average person…if you’re a super ambitious person today, you actually look back historically, I think, and look, well, actually it was possible to do more as an ambitious person. It was possible to find more leverage, to have fewer constrains in the past. It was then a period of about 50 years, like the great moderation, if you’d like, where a lot of that was constrained.

He lays out bull and bear cases for humanity, yet this is just a snippet:

We can imagine and creating world, whole worlds in which people can fulfill their ambitions and like the fullness of who they want to be in a way that is less damaging to others potentially. I mean, again, like you could say, that’s a very bullish case. There’s lots to critique in that, but there is something about the idea of virtualization as a way to enable many more people to achieve what they want to achieve, because we move from scarcity to abundance or potentially to abundance. Again, lots of footnotes on that, whether actually the metaverse as it is to actually emerging will permit that. I think the bear cases well, actually what the internet does is exposes us to, as you’ve already said, like a global competition where previously there was a local one, it sort of amplifies inequalities rather than dampening them.

The internet obviously accelerated learning for the motivated. I think it was on Smartless that Steph Curry admitted that Wemby can do that tennis ball dribbling drill as well as he can.

There’s this idea that the reason the 4-minute mile threshold was breached quickly and by many people once Roger Bannister finally broke the long elusive mark was psychology. The fact that someone proved it possible boosted other elite runners’ hope and motivation.

[It’s not something I’ve studied, but perhaps that’s one of those “just-so” causation stories that sounds plausible. In Ed Thorp’s autobiography, he says the reason he worked so hard to crunch the numbers in card-counting by hand was that he knew the pace of computing progress in the mid-60s meant many researchers would publish the calculations within a year or so of his frantic effort, and he wanted to be first. Maybe the 4-minute mile was already being seen less as an asymptote and more of an inevitability, and Bannister was the first of an already-oncoming pack.]

The internet feels like a variance pump because it turbo boosts Mendelian experimentation. The YouTube subculture of speedrunning looks like a Game Genie to someone raised on Metroid.

Reinforcement learning on all human knowledge and activity is the next turn of the crank. Recursion will mean later turns of the crank will not only come faster but possibly without our hand on it. We don’t really know where it goes in the long run (I don’t know if long-run means the next Haley’s comet, the next World Cup, or the Super Bowl), but in the meantime we can see that the range of ability is widening.

Now if leverage, a word embodying technology in the Archimedean sense, is accruing much faster to the top of the range, then Clifford will have spoken about variance when he should have been speaking about skew and kurtosis. To the initiated, it’s the strangle that’s interesting, not the straddle.

In options trading, there’s a structure called an Iron Butterfly. Like the band. It’s a long strangle (own the wings) and short straddle (the meat or body of the fly). It’s characterized as a short vol trade that has capped downside because you clip the losses in the tails. But if you ratio the legs of the trade to be long extra strangles, you could have a vega-neutral iron butterfly. This trade is long “vol gamma” (“volga”) or as some prefer to say, long vol of vol. It’s a second-order bet.

I’m not quite sure what the real-life activities are that would map to this idea. In investing, the mapping is probably more straightforward. You can literally own strangles and then continue to invest in all the forms of carry that have been documented to work. If you think the US stock market is TBTF, then you can just stick with the mother of all carry, equity risk premia, so instead of moaning about boomers’ influence, profit from it.

In a mature society, there’s an inertia, a calcification of the state’s administrative bones, protectionism, regulation and Nimbyism that spans across the right and left. The horseshoe is not a curious accident but unison decrepit impulses that reside in people who otherwise claim to only like chocolate or only like vanilla. The collision of variance suppression and variance amplification is a predictable human-paced response to technology’s scaling laws.

When it comes to real-life, we say things like “going out and meeting people is long vol”, but it’s harder to categorize activities as vol-neutral yet long vol-of-vol. Second-order Greeks are weird. Clifford’s a very smart guy, he may have been thinking in wings, but colloquially speaking in terms of variance. A commitment to TBTF, even if artificial, stabilizes variance. The artificial part has a lot of institutional cement holding it together and while the crack is a when, not if, the timing is uselessly Poisson.

You don’t want to be naked long or short vol. You want the vol of vol. We just gotta figure out what that means.

investing orbits

Here’s a summer reading book rec for investors:

My wife and I are both reading this. It’s laugh-out-loud funny. Gary is an excellent writer. The novel is written from the point of view of an elite school’s endowment CIO. It presents as a series of meetings with prospective managers, deals with politics within the endowment but also with the external culture of the investing world. If you are in finance, Gary’s sharp eye will delight you til no end.

I’m less than halfway through it and already I can’t recommend it enough. It was recommended to me by an allocator (thanks Tom!) and I saw in a recent Byrne Hobart letter that one of Byrne’s friends physically accosted him for not having read this book yet.

You can see Matt Levine’s endorsement in the screenshot. I wouldn’t have articulated what Matt wrote, but once he said it, I noticed that’s the exact feeling I get reading it.

The CIO’s banter, verbal chess, and inner monologue reveal a fox-like savvy honed by years of battle with both the market and the managers who make convincing cases for how they’ve mastered them. It gave me a tremendous appreciation for the difficulty of the job. If you are not a professional investor and have confused the most generous market run in anyone’s living memory for your own brilliance, then considering the CIO’s constraints will update your context for the pro version.

I found this recently reinforced by Jeremy Giffon in this terrific interview on ILTB.

Patrick: You have this funny view that the whole myth of how difficult it is to beat the market, however you want to define the market, is wrong. I’m curious for you to expound on that. That seems to have become, post-Jack Bogle, one of the deeply held truths of the market is that it’s extraordinarily difficult to beat the market, so you shouldn’t even try. You should just opt out of the battle. I think you have a very different view on this.

Jeremy: Buffett and Munger were my main teachers on investing. Buffett says that he wants his estate outside of Berkshire to be put in the S&P. That’s his advice to the general public. People take that to say that Buffett’s saying you can’t beat the market. I don’t think that’s what he’s saying. I think he’s saying for the average person, you shouldn’t try and beat the market. Implicit in that statement is leaving out any sort of active investor. Maybe the anecdotal side would be Buffett saying you should put all your money into the S&P. That’s the most rational thing you should do. On the other side is the sort of empirical argument, which is, look, most professionals don’t even beat the market after fees. This is this one-two punch of — the godfather of investing says, don’t try. Seemingly the smartest people with the best incentives in the world can’t do it.

And then the other thing is, for a professional manager — and this is sort of the paradox with the Buffett thing — it is really hard to beat the market because you have all these other factors that the average person doesn’t have. And this is the Peter Lynch argument — and increasingly I think Peter Lynch was a genius about this — which is that, yeah, when you’re a professional manager, by and large, you have all these mandates, you’re running a business, you have customers that you need to keep happy. It’s more difficult for the professional money manager to beat the market than the average amateur.

This is from Mandy Xu at the CBOE this week:

The outperformance of small-caps is a sign that the equity rally – which has long been dominated by the mega-cap Tech names – is starting to broaden out. In fact, over the past month, Tech has been the worst performing sector (-10%) while YTD laggards such as Healthcare and Financials have been the best performing (+12% and +8%, respectively). The calm at the index level (SPX Index -1.7% over the past month) belies these large rotations underneath the surface. This is why single stock volatility has been so elevated, even as the VIX® Index has fallen. The spread between the two, as measured by the VIXEQSM-VIX Index spread, widened to an all-time high of 31% last week.

If the single stock volatility is high relative to the index volatility, that’s another way to say the realized correlation between the stocks is very low. The index is dampening volatility because it’s acting well-diversified. A so-called stock-pickers market.

There’s so much violence under the surface. A momentum rotor whirring to give different categories an unpredictable spotlight before abruptly re-targeting.

I’m going to think aloud here a bit.

On the one hand, the momentum rotor feels like a market technicals concept. It’s the signature of flows and liquidity reaction functions. The intent of the orders that generate these flows might have a fundamental thesis behind them. In an investing mind. The trading world is indifferent to the ultimate intent but seeks to collect a service fee by spreading the acute dollar pressure in one part of the investing crust to another part of the surface.

From this perspective, the marginal price is set by an active investor. Perhaps the cumulative orders of levered pods.

At the same time, we hear of the “passive” bid. The Trump accounts and their monogamy to the SP500 (for the moment anyway) being yet one more increment to the bid.

If passive is the marginal price setter, I’d actually expect correlations to be structurally increasing. Not only do they seem to be structurally falling, they are conspicuously dormant at today’s historical lows.

I’m not sure the best way to reconcile these arguments. Is it an artifact of observation at a short time scale (rotor flows) vs a longer time scale (a slice of S in the GDP identity is pro-rata routed to the SP500 as long as the economy grows)? It’s reminiscent of the Earth’s dual rotation, where the planet spins on its own axis while orbiting the sun. The momentum rotor is called a “day” and the steady levitation of valuation comes from the passage of the “years”.

Regardless of the reconciliation of orbits or lack thereof, I am fractured by an ongoing dissonance:

I don’t discuss any of this in the Investment Beginnings Course!

It’s easy to anticipate a commoner’s consolation. “Kris, you are right to be teaching the textbook basics; we want the kids to learn investing, not gambling.” But it does feel quaint and too convenient to not address the marginal price setter. Buffett does so in a particularly striking way based on Graham’s allegory:

He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him…

Mr. Market has another endearing characteristic: He doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.

Mr. Market is there to serve you, not to guide you.

Yet, I have my humble reservations about Buffet’s view. It’s not that I think it’s wrong, it’s that it leaves you in a quandary about a critical aspect of decision-making. How do you weigh information when forming an opinion?! A strict reading of Buffet is that Mr. Market is emotional and irrational. But traders are taught to respect bids and offers. They are made with real money in proportion to conviction. It’s exactly why we say betting is a tax on bullshit. The essence of trading decisions is how you form priors and then Bayesian update. You can’t ignore bids and offers if you think they contain information (and you certainly would care about if the bids and offers are forced or “uneconomic”).

[The maximalist Buffet view is that “short-term”, an admittedly poorly defined descriptor, price behavior contains no information. I’m not actually opposed to this possibility under some conditions but it’s obviously not universally true. The price signals from shortages and surpluses in the physical world matter. It’s the entire basis of capitalism. Insofar as share prices are an inference on the supply and demand of the physical world, we should not ignore their deltas. But the amplification embedded in the math of capitalizing those inferences into a multiple leaves a lot of room for accepting and refuting its justifications.]

Circling back to what I teach the kids in the future or possible course edits might be to discuss macro simply in terms of Kalecki-Levy type accounting identities. They aren’t predictive but they are explanatory. Every liability is someone else’s asset. So if the G deficit spends, the private sector savings mechanically increase (I need to review the framework, to be accurate in teaching it, but you get the gist). Some of that S will be siphoned into stocks, creating structural demand to be weighed against the arrival of issuance (ie supply).

From that foundation, one can see the movement of the index of all corporate shares as one orbit, and the micro discernment of relative value underneath being the subject of traditional valuation canon, while the trading/gambling science informing the physical “equations” that govern the sector rotor.

I stuck with physics in adherence to the orbital analogy but we all know investing is biology.

But I’ll wrap with a quote from my article about why it feels like astrology (this remains the most widely read post in moontower history):

In a recent interview on Corey Hoffstein’s Flirting With Models, volatility manager Cem Karsan explains:

In the very long term, all that matters is cash flows. At some point you’re gonna have a liquidity crisis and when the liquidity is not available, companies have to create their own liquidity and that’s where fundamentals matter…they matter, to the extent that they are necessary for purchasing their own stock or buying other companies.

I’ve used this analogy before, it’s kind of hokey, but I can’t think of a better one. If you’re on an airplane, 30,000 feet off the ground, that 30,000 feet off the ground is the valuation gap. Valuations are really high, but those engines are firing. Are you worried up in that plane about the valuations or are you worried about the speed and trajectory of where you’re going, based on the engines, based on the flows? The flows are what matter for where you’re going.

But when all of a sudden those engines go off, how far off the ground you are is all that matters. And so, [valuation] is more of a risk management tool, and ultimately it really matters when you have a liquidity crisis. It also matters if rates were to go back to 8, 9, 10%. Something crazy again, where nobody can borrow money, and there is no liquidity. Cash flows are all that matters again and we have a world where fundamentals are all that matters. So I want to be clear. It’s not that fundamentals don’t matter at all, it’s that they don’t matter in a world of massive liquidity.

I’m not naive enough to envision a unifying theory of investing, but teaching the class does motivate an impulse to do better than the textbook in tying things together in a way that is not just correct-ish but useful and relevant. And respectful to preteens and teens’ intellects, for whom education is increasingly patronizing.

present tense

I turn 48 today. Once again grateful that another year of life insurance premium went to waste. It’s a reflective one, not because of me but because my eldest turns 13 tomorrow. I didn’t ask for it to be reflective, but my wife was watching old videos of him from ages 2 to 5 before bed and I got drawn in.

I never seek out the old videos. I figure one day I will when I need to make a slideshow or something. It’s a strange feeling. Because I forget what their little voices and mannerisms were like, so it feels like I’m watching a film that wasn’t actually my own life. And in that period, their constant need for you absorbed all your free time and energy. It’s a moment where all the young parents reading are in right now feels like forever. When you’re on the playground with your toddler and think how a 1st grader seems so old. Be careful ruffian, can’t you see my boy is only two and a half.

But it’s a flash. And all of it that absorbs you right now will cease to be remembered in detail. Only in shape. I can’t tell you about any one Saturday, but I can tell you about all of them together. The Tilden train every Saturday. Your day’s 2 halves. Before and after a nap. Each part starts with another coffee.

I’m not here to say enjoy it because it’s fleeting. I mean it is, but another phase will start. And it’s great. They’re all great. But if my memory of only 10 years ago is already foggy, I’ll predict that will be true for all that’s happening now when I’m 58.

I think I used to carry some anxiety about “will I remember this?”, “how will I remember this?” And you don’t really think about how the kid’ll remember this because you know they won’t. But as they get to elementary school age and older you know they’ll remember. And everyone wants to do core-memory-maxxxing for their kids. Us too. It would be nice if when they’re grown they look at their childhoods fondly. Or even better, if they think it helped them become whoever they’ve become, especially if they’re proud of that person.

Enjoy it, but not because it’s fleeting and not because you’re playing memory inception.

Enjoy it because it’s all there is.

You have no control over how matter might organize itself to bombard all that you love, all that you remember, and how you remember it. Your mind mediates reality, which itself we can only glimpse from the limited frames of our attention. The whole you-don’t-notice-your-breathing-until-I-say-pay-attention-to-your-breathing thing. The memories are sensitive to not only what you happened to notice but on the revisions that life’s future path dependence cast backwards.

The personal past (as opposed to big H History) to me is a social thing. A laughback with friends. A reminiscence you bond over. It’s not something I care to meditate alone on. Meanwhile, the future is a paradox. You want to watch your kids’ story unfold. You want to see the world with your partner and loved ones. There’s so much to look forward to. Yet you want time to slow down. You’ve got an awesome trip coming up in 6 months, but you don’t want to say “hurry up and get here” because the last thing you want to say is “hurry and let my kids/parents/pets be 6 months older”.

My 13-year-old is building a gym in the garage. It’s that time of life for him. He notices who has a 6-pack when they play shirts and skins. He wants to be stronger in the paint. I’ve been selling stuff on FB marketplace to make space for this iron temple. This week I sold a piano stool to the most energetic 82-year-old woman. She was apparently telling her karate instructor she never learned music and he offered to teach her piano. So here she is, stoked to be learning something new. You’d like to see that every day.

Knowledge and preparation demand we think of the past and the future. But you don’t want to live there.

I leave you with one of my favorite songs.

Moontower #320

In this issue:

  • investing orbits
  • present tense

Friends,

I save my editorializing for the section at the end today. Let’s go straight to Money Angle.

Money Angle

This week, I take the 12+ year-olds into the lab during market hours to buy their first portfolios for real. You can see the course recap and guide for prepping for the lab.

💾Download the course recap

What’s inside:

  • What we covered: businesses → compounding → picking stocks → risk → markets
  • Where investment returns come from
  • Why a long time horizon changes how you invest
  • What to own besides stocks, and why not bonds
  • The effect of valuations and fees on returns
  • Three starter portfolios, plus rules for picking individual stocks
  • A checklist for lab day

[The language in the recap is AI-talk which I hate too, but the material is certainly what I want to convey. Unlike writing this letter, I need to be efficient and not mastermind every word to actually make this stuff happen.]

For all the course materials see:

🧠The Investment Beginnings Course Page

Money Angle For Masochists

Here’s a summer reading book rec for investors:

My wife and I are both reading this. It’s laugh-out-loud funny. Gary is an excellent writer. The novel is written from the point of view of an elite school’s endowment CIO. It presents as a series of meetings with prospective managers, deals with politics within the endowment but also with the external culture of the investing world. If you are in finance, Gary’s sharp eye will delight you til no end.

I’m less than halfway through it and already I can’t recommend it enough. It was recommended to me by an allocator (thanks Tom!) and I saw in a recent Byrne Hobart letter that one of Byrne’s friends physically accosted him for not having read this book yet.

You can see Matt Levine’s endorsement in the screenshot. I wouldn’t have articulated what Matt wrote, but once he said it, I noticed that’s the exact feeling I get reading it.

The CIO’s banter, verbal chess, and inner monologue reveal a fox-like savvy honed by years of battle with both the market and the managers who make convincing cases for how they’ve mastered them. It gave me a tremendous appreciation for the difficulty of the job. If you are not a professional investor and have confused the most generous market run in anyone’s living memory for your own brilliance, then considering the CIO’s constraints will update your context for the pro version.

I found this recently reinforced by Jeremy Giffon in this terrific interview on ILTB.

Patrick: You have this funny view that the whole myth of how difficult it is to beat the market, however you want to define the market, is wrong. I’m curious for you to expound on that. That seems to have become, post-Jack Bogle, one of the deeply held truths of the market is that it’s extraordinarily difficult to beat the market, so you shouldn’t even try. You should just opt out of the battle. I think you have a very different view on this.

Jeremy: Buffett and Munger were my main teachers on investing. Buffett says that he wants his estate outside of Berkshire to be put in the S&P. That’s his advice to the general public. People take that to say that Buffett’s saying you can’t beat the market. I don’t think that’s what he’s saying. I think he’s saying for the average person, you shouldn’t try and beat the market. Implicit in that statement is leaving out any sort of active investor. Maybe the anecdotal side would be Buffett saying you should put all your money into the S&P. That’s the most rational thing you should do. On the other side is the sort of empirical argument, which is, look, most professionals don’t even beat the market after fees. This is this one-two punch of — the godfather of investing says, don’t try. Seemingly the smartest people with the best incentives in the world can’t do it.

And then the other thing is, for a professional manager — and this is sort of the paradox with the Buffett thing — it is really hard to beat the market because you have all these other factors that the average person doesn’t have. And this is the Peter Lynch argument — and increasingly I think Peter Lynch was a genius about this — which is that, yeah, when you’re a professional manager, by and large, you have all these mandates, you’re running a business, you have customers that you need to keep happy. It’s more difficult for the professional money manager to beat the market than the average amateur.

This is from Mandy Xu at the CBOE this week:

The outperformance of small-caps is a sign that the equity rally – which has long been dominated by the mega-cap Tech names – is starting to broaden out. In fact, over the past month, Tech has been the worst performing sector (-10%) while YTD laggards such as Healthcare and Financials have been the best performing (+12% and +8%, respectively). The calm at the index level (SPX Index -1.7% over the past month) belies these large rotations underneath the surface. This is why single stock volatility has been so elevated, even as the VIX® Index has fallen. The spread between the two, as measured by the VIXEQSM-VIX Index spread, widened to an all-time high of 31% last week.

If the single stock volatility is high relative to the index volatility, that’s another way to say the realized correlation between the stocks is very low. The index is dampening volatility because it’s acting well-diversified. A so-called stock-pickers market.

There’s so much violence under the surface. A momentum rotor whirring to give different categories an unpredictable spotlight before abruptly re-targeting.

I’m going to think aloud here a bit.

On the one hand, the momentum rotor feels like a market technicals concept. It’s the signature of flows and liquidity reaction functions. The intent of the orders that generate these flows might have a fundamental thesis behind them. In an investing mind. The trading world is indifferent to the ultimate intent but seeks to collect a service fee by spreading the acute dollar pressure in one part of the investing crust to another part of the surface.

From this perspective, the marginal price is set by an active investor. Perhaps the cumulative orders of levered pods.

At the same time, we hear of the “passive” bid. The Trump accounts and their monogamy to the SP500 (for the moment anyway) being yet one more increment to the bid.

If passive is the marginal price setter, I’d actually expect correlations to be structurally increasing. Not only do they seem to be structurally falling, they are conspicuously dormant at today’s historical lows.

I’m not sure the best way to reconcile these arguments. Is it an artifact of observation at a short time scale (rotor flows) vs a longer time scale (a slice of S in the GDP identity is pro-rata routed to the SP500 as long as the economy grows)? It’s reminiscent of the Earth’s dual rotation, where the planet spins on its own axis while orbiting the sun. The momentum rotor is called a “day” and the steady levitation of valuation comes from the passage of the “years”.

Regardless of the reconciliation of orbits or lack thereof, I am fractured by an ongoing dissonance:

I don’t discuss any of this in the Investment Beginnings Course!

It’s easy to anticipate a commoner’s consolation. “Kris, you are right to be teaching the textbook basics; we want the kids to learn investing, not gambling.” But it does feel quaint and too convenient to not address the marginal price setter. Buffett does so in a particularly striking way based on Graham’s allegory:

He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him…

Mr. Market has another endearing characteristic: He doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.

Mr. Market is there to serve you, not to guide you.

Yet, I have my humble reservations about Buffet’s view. It’s not that I think it’s wrong, it’s that it leaves you in a quandary about a critical aspect of decision-making. How do you weigh information when forming an opinion?! A strict reading of Buffet is that Mr. Market is emotional and irrational. But traders are taught to respect bids and offers. They are made with real money in proportion to conviction. It’s exactly why we say betting is a tax on bullshit. The essence of trading decisions is how you form priors and then Bayesian update. You can’t ignore bids and offers if you think they contain information (and you certainly would care about if the bids and offers are forced or “uneconomic”).

[The maximalist Buffet view is that “short-term”, an admittedly poorly defined descriptor, price behavior contains no information. I’m not actually opposed to this possibility under some conditions but it’s obviously not universally true. The price signals from shortages and surpluses in the physical world matter. It’s the entire basis of capitalism. Insofar as share prices are an inference on the supply and demand of the physical world, we should not ignore their deltas. But the amplification embedded in the math of capitalizing those inferences into a multiple leaves a lot of room for accepting and refuting its justifications.]

Circling back to what I teach the kids in the future or possible course edits might be to discuss macro simply in terms of Kalecki-Levy type accounting identities. They aren’t predictive but they are explanatory. Every liability is someone else’s asset. So if the G deficit spends, the private sector savings mechanically increase (I need to review the framework, to be accurate in teaching it, but you get the gist). Some of that S wll be siphoned into stocks creating structural demand to be weighed against the arrival of issuance (ie supply).

From that foundation, one can see the movement of the index of all corporate shares as one orbit, and the micro discernment of relative value underneath being the subject of traditional valuation canon, while the trading/gambling science informing the physical “equations” that govern the sector rotor.

I stuck with physics in adherence to the orbital analogy but we all know investing is biology.

But I’ll wrap with a quote from my article about why it feels like astrology (this remains the most widely read post in moontower history):

In a recent interview on Corey Hoffstein’s Flirting With Models, volatility manager Cem Karsan explains:

In the very long term, all that matters is cash flows. At some point you’re gonna have a liquidity crisis and when the liquidity is not available, companies have to create their own liquidity and that’s where fundamentals matter…they matter, to the extent that they are necessary for purchasing their own stock or buying other companies.

I’ve used this analogy before, it’s kind of hokey, but I can’t think of a better one. If you’re on an airplane, 30,000 feet off the ground, that 30,000 feet off the ground is the valuation gap. Valuations are really high, but those engines are firing. Are you worried up in that plane about the valuations or are you worried about the speed and trajectory of where you’re going, based on the engines, based on the flows? The flows are what matter for where you’re going.

But when all of a sudden those engines go off, how far off the ground you are is all that matters. And so, [valuation] is more of a risk management tool, and ultimately it really matters when you have a liquidity crisis. It also matters if rates were to go back to 8, 9, 10%. Something crazy again, where nobody can borrow money, and there is no liquidity. Cash flows are all that matters again and we have a world where fundamentals are all that matters. So I want to be clear. It’s not that fundamentals don’t matter at all, it’s that they don’t matter in a world of massive liquidity.

I’m not naive enough to envision a unifying theory of investing, but teaching the class does motivate an impulse to do better than the textbook in tying things together in a way that is not just correct-ish but useful and relevant. And respectful to preteens and teens’ intellects, for whom education is increasingly patronizing.

From My Actual Life

I turn 48 today. Once again grateful that another year of life insurance premium went to waste. It’s a reflective one, not because of me but because my eldest turns 13 tomorrow. I didn’t ask for it to be reflective, but my wife was watching old videos of him from ages 2 to 5 before bed and I got drawn in.

I never seek out the old videos. I figure one day I will when I need to make a slideshow or something. It’s a strange feeling. Because I forget what their little voices and mannerisms were like, so it feels like I’m watching a film that wasn’t actually my own life. And in that period, their constant need for you absorbed all your free time and energy. It’s a moment where all the young parents reading are in right now feels like forever. When you’re on the playground with your toddler and think how a 1st grader seems so old. Be careful ruffian, can’t you see my boy is only two and a half.

But it’s a flash. And all of it that absorbs you right now will cease to be remembered in detail. Only in shape. I can’t tell you about any one Saturday, but I can tell you about all of them together. The Tilden train every Saturday. Your day’s 2 halves. Before and after a nap. Each part starts with another coffee.

I’m not here to say enjoy it because it’s fleeting. I mean it is, but another phase will start. And it’s great. They’re all great. But if my memory of only 10 years ago is already foggy, I’ll predict that will be true for all that’s happening now when I’m 58.

I think I used to carry some anxiety about “will I remember this?”, “how will I remember this?” And you don’t really think about how the kid’ll remember this because you know they won’t. But as they get to elementary school age and older you know they’ll remember. And everyone wants to do core-memory-maxxxing for their kids. Us too. It would be nice if when they’re grown they look at their childhoods fondly. Or even better, if they think it helped them become whoever they’ve become, especially if they’re proud of that person.

Enjoy it, but not because it’s fleeting and not because you’re playing memory inception.

Enjoy it because it’s all there is.

You have no control over how matter might organize itself to bombard all that you love, all that you remember, and how you remember it. Your mind mediates reality, which itself we can only glimpse from the limited frames of our attention. The whole you-don’t-notice-your-breathing-until-I-say-pay-attention-to-your-breathing thing. The memories are sensitive to not only what you happened to notice but on the revisions that life’s future path dependence cast backwards.

The personal past (as opposed to big H History) to me is a social thing. A laughback with friends. A reminiscence you bond over. It’s not something I care to meditate alone on. Meanwhile, the future is a paradox. You want to watch your kids’ story unfold. You want to see the world with your partner and loved ones. There’s so much to look forward to. Yet you want time to slow down. You’ve got an awesome trip coming up in 6 months, but you don’t want to say “hurry up and get here” because the last thing you want to say is “hurry and let my kids/parents/pets be 6 months older”.

My 13-year-old is building a gym in the garage. It’s that time of life for him. He notices who has a 6-pack when they play shirts and skins. He wants to be stronger in the paint. I’ve been selling stuff on FB marketplace to make space for this iron temple. This week I sold a piano stool to the most energetic 82-year-old woman. She was apparently telling her karate instructor she never learned music and he offered to teach her piano. So here she is, stoked to be learning something new. You’d like to see that every day.

Knowledge and preparation demand we think of the past and the future. But you don’t want to live there.

I leave you with one of my favorite songs.

[The musical build from the delicate flanger-tinged mixolydian walkdown to the drop-d dirt of the chorus and its desperate message…straight into the vein.]

 

This week in The Options Trench

📺Erik and I decode the inputs to Black-Scholes-Merton

 

Stay groovy

☮️

Moontower Weekly Recap