This is an email I received from a long-time friend and successful founder of an options trading business (he is bankrolled by a prop shop). He’s chopped a lot of wood, so I changed some details to keep insiders from figuring out who he is. He was very forthcoming and approved this of course.
My understanding is that loss aversion is the idea/phenomenon of different reactions to “losing” versus “winning” despite the same (or even a worse) net actual outcome. I believe there are several studies of this in a controlled/lab setting, but I didn’t go back to review, as I just needed to get this sent!
The loss aversion reference from our call, referred to annual p/l, as I recall. Below, are a few examples (with more or less real world inputs from my past few years).
-In scenario #1, we are having a rough year, losing after-expenses around mid-year. Then, we catch one big winner and a strong q4, including 3mm in the last week of the year during the xmas crash. We finish the year +4mm net. Overall, that’s a mediocre year to historical avg. But, given the alternative– an ugly losing year with no bonus, and possible clawbacks going forward, I’m thrilled to realize 750k or so from that slice of my comp (my specific team performance). That was basically 2018…
-In scenario #2 we are having a home run year, +20mm in the account in March. Then the Cboe closes for 6 weeks while we have our biggest position in 10 years of XXX trading. The position bleeds, we have no outs, no volume… then the XXX makes several gaps from [low number to high number], and right back to [low number], on no liquidity. We negatively scalp (10mm). XXX p/l is now gone, and the product is dead, and Cboe remains closed. Meanwhile, Softbank happens in tech, and we are short a lot of tech vega in YYYY, etc. We lose another 5mm there. So we go from +20mm to +2mm in 3 months (expenses never slow down). We spend the 2nd half of the year grinding back some $$, and finish around +7mm. I get paid a lot more than in scenario #1, but I have horrible PTSD, I don’t sleep for months, I lament (daily..) what could have been if I had booked a 30mm p/l year, and it’s misery all around. (My XXX trader even had a nervous breakdown and had to take a leave from work.) This is obviously 2020. Despite the much better outcome, it’s a much “worse” year in terms of performance/comp. but it’s all in my head. Overall, I was paid more, which in trader land, should always be better. Right? Right?!
I think these longer term (annual comp) examples illustrate the concept of loss aversion quite well. But there are of course countless others. Just Friday, as I typed this, another arose. We had a winner to the morning news/gap in ZZZZ. Long gamma was good for about +50k. Market opened, we start trading, stock keeps going. 25%, 30%… almost 50%. We were hedging deltas, and then sold some gamma that was quickly awful. We now have an Opening p/l +130k, day p/l (60k.): net +70k. The outcome is better than before, but I’m a hot mess, cursing my decisions and the stock. Better outcome, worse head space. There are so many examples of loss aversion, many of which I’m sure you have considered during your career. But annual comp and intraday hedging of a winner are 2…
I’m not sure if this is at all interesting as a potential future post, but the topic fascinates me. The human brain is just not wired to properly handle these things very well. Or, at least mine is not.
That story is the embodiment of Lawrence Yeo’s terrific Speculation: A Game You Can’t Win.
I realize the numbers my buddy is throwing around make this sound like a high-class problem. But I’ll point you to a post that will prompt you to think deeper before concluding you can’t learn from it.
- Are You Playing to Play, or Playing to Win? (26 min read)
Cedric Chin This post is fantastic on its own. You might even realize you’re a…“scrub”. But it’s a giant doorway to self-examination. It makes you wonder if you are playing to win. But, and I think this is actually unintentional, the post shows the major limitation of analogizing games to life. Check my short tweet thread before or after reading the post to see what I mean. The expression “play stupid games, win stupid prizes” comes to mind. Only you can decide what’s stupid. We are seeing this happen in real-time, with people calling this period of massive turnover and quitting the “Great Resignation”. Then again, just as we mix up bull markets with brains, there’s a good chance asset markets have pulled many people closer to “their number” and accelerated the types of questions many would usually wait another decade to wrestle with. [The nihilistic whisper in my ear, is the quickened trajectory accelerates the feeling that as we peel back one delusion we just find another. If the onion of delusions was a grand secret, its nature was typically revealed to the aged under the stacking pressure of successive self-crises. But today, that reality is creeping broadly into younger cohorts who, when they threaten to not play traditional games, seem to be serious.]