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.


Moontower #125

Welcome shareholder. You probably own an index.

An index is like a box of stocks. You might see the word “value” in the description of the box you own. Let’s find out what’s inside this box of supposed bargains.

The big reveal…

Twitter avatar for @GunjanJSGunjan Banerji @GunjanJS

AMC and Avis are now the biggest holdings in the iShares Russell 2000 Value ETF #valueinvesting $CAR

Image

Congratulations?

Wanna know another name you definitely own if you own any index not categorized as “value”? Here’s a hint, it goes vroom without a sound.

Destroy passive indexing for years to come?! All caps too. Sounds serious.

But is it?

Twitter avatar for @coloradotravisTravis @coloradotravis

So this is a fascinating thesis that I think a lot of people are dismissing out of hand just because it seems too extreme. But let’s unpack for a sec here what @SqueezeMetrics (who, worryingly, has a tendency to be right) is saying & attach it to some observed phenomena. 1/

SqueezeMetrics @SqueezeMetrics

@AlexLachance11 @bogosorting THE PEOPLE WHO ARE BUYING CALL OPTIONS ON TESLA RIGHT NOW ARE DOING SO AS A HEDGE AGAINST THE *VERY REAL* POSSIBILITY THAT TESLA STOCK GAMMASPLODES TO 25% OF THE S&P 500 (12.5% OF GLOBAL EQUITIES), DESTROYING PASSIVE INVESTING FOR YEARS TO COME

I’ve followed Squeeze and Travis for a long time. They are sharp. The conversation woke up sensei Bau.

The insights he added remind me how disinflationary the internet is. This thread is totally free:

Read the thread for more detail. It’s about the nature of a squeeze that uses options to push a stock higher. I’ll circle back to the core insight of the thread but I want to back up for a moment because there’s an opportunity to learn about how to think about options generally.

How Options Complete A Market

Out-of-the-money call options are “soft” deltas. If you bought the stock instead of calls, you bought “hard” deltas. Soft deltas can decay with time and, depending on their moneyness, contractions in implied volatility. The distinction actually highlights why options are useful.

Options “complete” the picture for a stock.

What does that mean?

Consider 2 stocks 1 both trading for $100:

  • Stock A: Has a uniformly equal chance of being worth any whole dollar amount between $80 and $120. Its value averages to $100.
  • Stock B: Has a 90% chance of going to 0, and a 10% chance of going to $1,000. Its expected value is also $100.

If you just pulled up either of these tickers you’d see a $100 stock, but the distributions that drive that price are vastly different. A single price lacks the dimensionality to convey the underlying distribution. Alas, the options market will show you exactly what it thinks the distribution is. It “completes” the information.

Volatility, skew, and kurtosis can be extracted from an option surface across time to provide a 3-D probability picture (the odds of certain outcomes, by a certain date).

In the above example, the $750 strike call is worthless for Stock A and worth $25 for Stock B (10% probability x $250 payoff if the stock goes to $1,000).

Ok, let’s say I’m feeling benevolent and offer to sell you shares in either stock for $90 (and I mean truly benevolent. I’m not some Orlando homeowner pasting Zillow on its 90% of Zestimate bid because I have a meth lab in the basement). If you take either stock for $90, the expected return is exactly the same — $10.

But the risks, are totally different. If you choose Stock B, 90% of the time you lose all your money. This is counterbalanced by the 10% of the time that more than 10x your investment.

This takes us back to options. If you are bullish on a stock, you need to understand the scenarios. If that $100 stock price is being driven by a long right tail but a high probability of a crash, you will size your trade differently. In fact, you might prefer to buy call options since they are levered to that right tail return. There’s a nerd way to explain that, but we can do it far more simply. If you were the only person who knew Stock B’s distribution and everyone else in the world thought all $100 stocks had the same distribution you could offer to pay $1 for the $750 call. There would be many eager sellers who would sell you that “worthless” option, unknowingly handing you a 25x theoretical return on your investment (remember the Stock B $750 call is worth $25 because there’s a 10% chance it goes $250 in-the-money).

Options allow you to tune your trade expression to the bet you want to actually make.

This is why vertical spreads are such useful hedges to market-makers. The long and short positions in calls sterilize the effect of the tails (and nearly all the non-linear greeks) and turn the bet into a simple over/under or binary bet. If a $10 wide vertical is trading for $2.50, you don’t need to know anything about the distribution. You know that you are getting 3-1 odds on it the stock expiring above the higher strike 2.

Tuning Your TSLA Trade Expression

Back to white-hot TSLA. The company is valued at over $1T. I’ll ask some leading questions:

  • What is the underlying distribution imputing that valuation? Is it more similar to Stock A or Stock B?
  • Does your opinion make you want to replace your hard deltas with soft deltas?

For me, the more I think the stock price is driven by the right tail (vs the vol or first-moment outcomes) the more I want to “stock replace” with an option. An option is the correct expression of the bet because its value maps to a higher moment. Just like Stock B’s $750 strike was worth $25.

And the reason for this is not just because I’m looking up. It’s because I’m worried about what’s down below. I really want the put embedded in that call. I don’t want hard deltas when this thing rolls over.

Slow down. Don’t rush out and buy TSLA calls. You might be boarding a Higgins boat to Normandy. You are on the front lines with many YOLOs who got the same idea. You still have to deal with an important matter — price. What is the right price for the options? Even if call options are the right expression of a bullish bet on a liquidity spiral, you still need to estimate what the options should be worth.

I don’t have an answer to that of course. Whatever implied vols the calls are trading for is presumably the market’s best guess for what they are worth. But without looking at the prices, my “prior” is that the calls are overly expensive. Why would I expect that? Here’s my logic:

  1. My leading questions were meant to lead you to “options are the correct expression of the bullish TSLA bet”
  2. My powers of observation are not special. Many others realize this too and are buying calls.
  3. The right-tail risk is large and idiosyncratic. Therefore it is difficult to hedge. In fact, the only hedge is a margin of safety in the price and keeping the size of any short call position a relatively small part of your bankroll.
  4. There must be a satisfactory risk premium baked into the calls to compensate the sellers.

To understand how making the calls expensive foils buyers, let’s go a bit deeper by circling back to @bauhiniacapital.

Soft Deltas Depend On Price And Path

Let me start by re-printing @bauhiniacapital’s comments:

What I am getting at is that the ratio of how much people are putting into OTM calls – throwaway money – vs how much they get out of it is a) ridiculous and b) not scalable infinitely. People run out of money…

To find new people to FOMO into it requires more premium thrown away. The only way to maintain the squeeze forever cleanly is through straight delta. If done via options, you need path and disposable “entertainment value income

I emphasized those terms because it’s a sharp insight:

If done via options, you need path and disposable “entertainment value income

The nuance deserves more than a tweet so I’ll expand here.

  • Disposable “entertainment value incomeOption premium can be thought of as:

    the size of a stock’s future price change discounted by its probability

    The fair price of the premium relies most importantly on the future volatility of the stock (a quantity that cannot be observed today, of course). But like insurance, the lived experience of owning an out-of-the-money option is you usually lose your premium.

    So for the game to continue, the buyers of these options need to win. For them to win, either the sellers of the options need to lose OR the folks selling TSLA shares need to lose (which is another way of saying the stock needs to continue going up). So the stock requires more inflows OR the options need to be systematically too cheap.3

For the options to be structurally underpriced, the market makers need to be willing punching bags and this is not a feature we typically associate with that role. In fact, it’s the opposite. A prerequisite for survival is being a quick learner. You can beat them big once. But that usually just leads to a false sense of security, because they simply adapt. How? They will raise their volatility offers. I’m not a market maker (hell I’m not even employed, so I feel like AL Bundy writing about options this much…“Hey everyone I scored 4 touchdowns in one game in HS!”) but this is what I imagine:

    1. MM’s jack the vol way up to sell it, effectively sweeping bits and pieces of liquidity along the way.Market makers are quick to raise the vols when they see buying knowing that the momentum buyers are vol-insensitive. (If you have a buyer that has no reserve, you will crank the vol up as far as your competitors, who are in the same boat, will let you.4)
    2. With the vol high enough the gamma effect fallsWe don’t need to resort to technical explanations. Intuition works…a 5% move in a 100% implied vol stock is not even a standard deviation. The higher the vol, the larger the move required to necessitate gamma hedging.
    3. Time also works against an OTM optionAs time passes, the options greeks including its gamma decay further.

All of this splainin’ reduces to:

The people supplying the options are not “willing losers”. 5 They will only sell options they deem overpriced. In the long run, they tend to be right as evidenced by their persistent prosperity over many market regimes.

So what’s left?

  • PathFor the market makers and the buyers to win there is only one possibility. The path must roughly go straight up. And voila that is what’s happening. But the music will stop since that which is unsustainable, won’t be sustained. That says nothing of timing and I probably could have written the same thing a year ago, and it would have made the YOLOs amongst you poorer. What can I say, this is a free email. YMMV.I’ll turn back to @bauhiniacapital’s observation of the psychology:

    And one requires ever more inflows because the inflow is not sitting on #HugeGainz (if it did, it wouldn’t feel FOMO). On right tail outcome, it requires geometric growth in interest against arithmetic growth in supply (wealth of new FOMOers).

    The TSLA options bid is a Schellinged levered proxy bet on one-way demand overtaking the supply of issuance in a non-linear, non-elastic price crescendo.

Wrapping Up

  • Continued inflows are ultimately constrained by real economic income. Some questions I posed aloud in the thread:
    • Is it possible to decompose the bid stack into how thick the “entertainment value” bid is?
    • Can you map that to strike prices?Bau wondered how that maps to BTFD/income-draining risk-replenishment because at some point, ‘bad luck’ becomes negative reinforcement.
  • The duration and extent of what we are seeing in markets today raise a lot of questions about what we understand about economics, flows, and how returns are generated. Twitter aggregates provocative discussions on these topics. I felt that walking through these threads, I could add value to your understanding of options. As far as the broader dynamics, I’m just sense-making in public.
  • A recap of the scenario and how it relates to options:
    1. If the right tail is driving the expected return, call options are the vehicle to express that bet.
    2. Everyone is already trying to buy them.
    3. The price of the options is like a gate that modulates how big those flows need to be to trigger gamma squeezes.
    4. Any single outcome might work out for the buyers, but over time, winning requires an ever-increasing rate of inflow for the scheme to self-sustain.
    5. If buying soft-deltas via options is a losing game are buyers right back at square zero, needing to express the squeeze by just buying shares (ie hard deltas)?I don’t know.But I do know, if you’re a passive index buyer, hard deltas at a 1.2T market cap is what you got.
  • Just as I got to the end of writing this, the plot thickens.

If Elon wanted to minimize his slippage he could decide he didn’t want to sell more than 1% of the daily volume. If we assume TSLA trades 25-30mm shares a day and is around $1200 it would take him about 3 months to sell $20B worth of stock. This is a moving target, because if he fixes the $ amount he wants to sell at $20B then if the price falls he needs to sell more shares, and if the price rallies he’d need to sell less. The scenarios lengthen or shorten how long it would take to liquidate the shares respectively.

He could also decide to just fix how many shares he wanted to sell and simply accept whatever cash proceeds it generated.

He could also offer to swap them for Nissan which is worth $20B. Or for that matter any company in the bottom third of the entire SP500. Do you know what he can’t afford to buy for $20B?

All of SHIB.

Using The TSLA Price Endgame To Understand Options

Welcome shareholder. You probably own an index.

An index is like a box of stocks. You might see the word “value” in the description of the box you own. Let’s find out what’s inside this box of supposed bargains.

The big reveal…

Congratulations?

Wanna know another name you definitely own if you own any index not categorized as “value”? Here’s a hint, it goes vroom without a sound.

Destroy passive indexing for years to come?! All caps too. Sounds serious.

But is it?

Twitter avatar for @coloradotravisTravis @coloradotravis

So this is a fascinating thesis that I think a lot of people are dismissing out of hand just because it seems too extreme. But let’s unpack for a sec here what @SqueezeMetrics (who, worryingly, has a tendency to be right) is saying & attach it to some observed phenomena. 1/

SqueezeMetrics @SqueezeMetrics

@AlexLachance11 @bogosorting THE PEOPLE WHO ARE BUYING CALL OPTIONS ON TESLA RIGHT NOW ARE DOING SO AS A HEDGE AGAINST THE *VERY REAL* POSSIBILITY THAT TESLA STOCK GAMMASPLODES TO 25% OF THE S&P 500 (12.5% OF GLOBAL EQUITIES), DESTROYING PASSIVE INVESTING FOR YEARS TO COME

I’ve followed Squeeze and Travis for a long time. They are sharp. The conversation woke up sensei Bau.

The insights he added remind me how disinflationary the internet is. This thread is totally free:

Read the thread for more detail. It’s about the nature of a squeeze that uses options to push a stock higher. I’ll circle back to the core insight of the thread but I want to back up for a moment because there’s an opportunity to learn about how to think about options generally.

How Options Complete A Market

Out-of-the-money call options are “soft” deltas. If you bought the stock instead of calls, you bought “hard” deltas. Soft deltas can decay with time and, depending on their moneyness, contractions in implied volatility. The distinction actually highlights why options are useful.

Options “complete” the picture for a stock.

What does that mean?

Consider 2 stocks 1 both trading for $100:

  • Stock A: Has a uniformly equal chance of being worth any whole dollar amount between $80 and $120. Its value averages to $100.
  • Stock B: Has a 90% chance of going to 0, and a 10% chance of going to $1,000. Its expected value is also $100.

If you just pulled up either of these tickers you’d see a $100 stock, but the distributions that drive that price are vastly different. A single price lacks the dimensionality to convey the underlying distribution. Alas, the options market will show you exactly what it thinks the distribution is. It “completes” the information.

Volatility, skew, and kurtosis can be extracted from an option surface across time to provide a 3-D probability picture (the odds of certain outcomes, by a certain date).

In the above example, the $750 strike call is worthless for Stock A and worth $25 for Stock B (10% probability x $250 payoff if the stock goes to $1,000).

Ok, let’s say I’m feeling benevolent and offer to sell you shares in either stock for $90 (and I mean truly benevolent. I’m not some Orlando homeowner pasting Zillow on its 90% of Zestimate bid because I have a meth lab in the basement). If you take either stock for $90, the expected return is exactly the same — $10.

But the risks, are totally different. If you choose Stock B, 90% of the time you lose all your money. This is counterbalanced by the 10% of the time that more than 10x your investment.

This takes us back to options. If you are bullish on a stock, you need to understand the scenarios. If that $100 stock price is being driven by a long right tail but a high probability of a crash, you will size your trade differently. In fact, you might prefer to buy call options since they are levered to that right tail return. There’s a nerd way to explain that, but we can do it far more simply. If you were the only person who knew Stock B’s distribution and everyone else in the world thought all $100 stocks had the same distribution you could offer to pay $1 for the $750 call. There would be many eager sellers who would sell you that “worthless” option, unknowingly handing you a 25x theoretical return on your investment (remember the Stock B $750 call is worth $25 because there’s a 10% chance it goes $250 in-the-money).

Options allow you to tune your trade expression to the bet you want to actually make.

This is why vertical spreads are such useful hedges to market-makers. The long and short positions in calls sterilize the effect of the tails (and nearly all the non-linear greeks) and turn the bet into a simple over/under or binary bet. If a $10 wide vertical is trading for $2.50, you don’t need to know anything about the distribution. You know that you are getting 3-1 odds on it the stock expiring above the higher strike 2.

Tuning Your TSLA Trade Expression

Back to white-hot TSLA. The company is valued at over $1T. I’ll ask some leading questions:

  • What is the underlying distribution imputing that valuation? Is it more similar to Stock A or Stock B?
  • Does your opinion make you want to replace your hard deltas with soft deltas?

For me, the more I think the stock price is driven by the right tail (vs the vol or first-moment outcomes) the more I want to “stock replace” with an option. An option is the correct expression of the bet because its value maps to a higher moment. Just like Stock B’s $750 strike was worth $25.

And the reason for this is not just because I’m looking up. It’s because I’m worried about what’s down below. I really want the put embedded in that call. I don’t want hard deltas when this thing rolls over.

Slow down. Don’t rush out and buy TSLA calls. You might be boarding a Higgins boat to Normandy. You are on the front lines with many YOLOs who got the same idea. You still have to deal with an important matter — price. What is the right price for the options? Even if call options are the right expression of a bullish bet on a liquidity spiral, you still need to estimate what the options should be worth.

I don’t have an answer to that of course. Whatever implied vols the calls are trading for is presumably the market’s best guess for what they are worth. But without looking at the prices, my “prior” is that the calls are overly expensive. Why would I expect that? Here’s my logic:

  1. My leading questions were meant to lead you to “options are the correct expression of the bullish TSLA bet”
  2. My powers of observation are not special. Many others realize this too and are buying calls.
  3. The right-tail risk is large and idiosyncratic. Therefore it is difficult to hedge. In fact, the only hedge is a margin of safety in the price and keeping the size of any short call position a relatively small part of your bankroll.
  4. There must be a satisfactory risk premium baked into the calls to compensate the sellers.

To understand how making the calls expensive foils buyers, let’s go a bit deeper by circling back to @bauhiniacapital.

Soft Deltas Depend On Price And Path

Let me start by re-printing @bauhiniacapital’s comments:

What I am getting at is that the ratio of how much people are putting into OTM calls – throwaway money – vs how much they get out of it is a) ridiculous and b) not scalable infinitely. People run out of money…

To find new people to FOMO into it requires more premium thrown away. The only way to maintain the squeeze forever cleanly is through straight delta. If done via options, you need path and disposable “entertainment value income

I emphasized those terms because it’s a sharp insight:

If done via options, you need path and disposable “entertainment value income

The nuance deserves more than a tweet so I’ll expand here.

  • Disposable “entertainment value income

    Option premium can be thought of as:

    the size of a stock’s future price change discounted by its probability

    The fair price of the premium relies most importantly on the future volatility of the stock (a quantity that cannot be observed today, of course). But like insurance, the lived experience of owning an out-of-the-money option is you usually lose your premium.

    So for the game to continue, the buyers of these options need to win. For them to win, either the sellers of the options need to lose OR the folks selling TSLA shares need to lose (which is another way of saying the stock needs to continue going up). So the stock requires more inflows OR the options need to be systematically too cheap.3

For the options to be structurally underpriced, the market makers need to be willing punching bags and this is not a feature we typically associate with that role. In fact, it’s the opposite. A prerequisite for survival is being a quick learner. You can beat them big once. But that usually just leads to a false sense of security, because they simply adapt. How? They will raise their volatility offers. I’m not a market maker (hell I’m not even employed, so I feel like AL Bundy writing about options this much…“Hey everyone I scored 4 touchdowns in one game in HS!”) but this is what I imagine:

    1. MM’s jack the vol way up to sell it, effectively sweeping bits and pieces of liquidity along the way.

      Market makers are quick to raise the vols when they see buying knowing that the momentum buyers are vol-insensitive. (If you have a buyer that has no reserve, you will crank the vol up as far as your competitors, who are in the same boat, will let you.4)

    2. With the vol high enough the gamma effect falls

      We don’t need to resort to technical explanations. Intuition works…a 5% move in a 100% implied vol stock is not even a standard deviation. The higher the vol, the larger the move required to necessitate gamma hedging.

    3. Time also works against an OTM option

      As time passes, the options greeks including its gamma decay further.

All of this splainin’ reduces to:

The people supplying the options are not “willing losers”. 5 They will only sell options they deem overpriced. In the long run, they tend to be right as evidenced by their persistent prosperity over many market regimes.

So what’s left?

  • Path

    For the market makers and the buyers to win there is only one possibility. The path must roughly go straight up. And voila that is what’s happening. But the music will stop since that which is unsustainable, won’t be sustained. That says nothing of timing and I probably could have written the same thing a year ago, and it would have made the YOLOs amongst you poorer. What can I say, this is a free email. YMMV.I’ll turn back to @bauhiniacapital’s observation of the psychology:

    And one requires ever more inflows because the inflow is not sitting on #HugeGainz (if it did, it wouldn’t feel FOMO). On right tail outcome, it requires geometric growth in interest against arithmetic growth in supply (wealth of new FOMOers).

    The TSLA options bid is a Schellinged levered proxy bet on one-way demand overtaking the supply of issuance in a non-linear, non-elastic price crescendo.

Wrapping Up

  • Continued inflows are ultimately constrained by real economic income. Some questions I posed aloud in the thread:
    • Is it possible to decompose the bid stack into how thick the “entertainment value” bid is?
    • Can you map that to strike prices?Bau wondered how that maps to BTFD/income-draining risk-replenishment because at some point, ‘bad luck’ becomes negative reinforcement.
  • The duration and extent of what we are seeing in markets today raise a lot of questions about what we understand about economics, flows, and how returns are generated. Twitter aggregates provocative discussions on these topics. I felt that walking through these threads, I could add value to your understanding of options. As far as the broader dynamics, I’m just sense-making in public.
  • A recap of the scenario and how it relates to options:
    1. If the right tail is driving the expected return, call options are the vehicle to express that bet.
    2. Everyone is already trying to buy them.
    3. The price of the options is like a gate that modulates how big those flows need to be to trigger gamma squeezes.
    4. Any single outcome might work out for the buyers, but over time, winning requires an ever-increasing rate of inflow for the scheme to self-sustain.
    5. If buying soft-deltas via options is a losing game are buyers right back at square zero, needing to express the squeeze by just buying shares (ie hard deltas)?I don’t know.

      But I do know, if you’re a passive index buyer, hard deltas at a 1.2T market cap is what you got.

  • Just as I got to the end of writing this, the plot thickens.

If Elon wanted to minimize his slippage he could decide he didn’t want to sell more than 1% of the daily volume. If we assume TSLA trades 25-30mm shares a day and is around $1200 it would take him about 3 months to sell $20B worth of stock. This is a moving target, because if he fixes the $ amount he wants to sell at $20B then if the price falls he needs to sell more shares, and if the price rallies he’d need to sell less. The scenarios lengthen or shorten how long it would take to liquidate the shares respectively.

He could also decide to just fix how many shares he wanted to sell and simply accept whatever cash proceeds it generated.

He could also offer to swap them for Nissan which is worth $20B. Or for that matter any company in the bottom third of the entire SP500. Do you know what he can’t afford to buy for $20B?

All of SHIB.


[Macro] Voodoo Child (Slight Return)

The best thing I read last year was @jesse_livermore paper Upside Down Markets. I read it 3x. It’s 40,000 words and heavily footnoted and researched. It’s basically a book.

I took extensive notes on it. I re-factored them twice. If I sound crazy, it’s because it was the most educational economics piece I’ve ever read. Preemptive caveat, but that doesn’t say much. I did the bare minimum to get an economics degree. I have very weak opinions on macro because it’s so over my head it basically feels like voodoo.

But…

I also know I want to gag myself whenever I hear others talk about macro. You would too if you read this paper and then had to listen to any sentence that includes the word “inflation”. Macro is the ultimate tourist attraction. Snapping pictures of shiny explanations to show your friends at home. “Look at how much of the world I’ve seen and understand.”

It makes my eyes roll out of my head. Look, we don’t need tourists to pretend they’re experts. It’s ok for them to go to Times Square. To observe and take it in without feeling pressure to be cool or smart about knowing the real landscape. It’s ok to just not understand.

But if you care to understand and not just pretend, you need to stay awhile. This paper is a tour guide but not the hop-on, hop-off red bus kind. This guide has you crash on the futon before heading to the bodega on Avenue C as you prepare for another 10-mile spelunk of city alleys.

Jesse’s map will open your eyes. Built-up from basic accounting identities, it’s an example of the rigor you must take to actually make sense of an economy from 30,000 feet. The accounting framework alone is worth the journey. Jesse doesn’t call the sensitivities Greeks, but he could have. What are the dependencies? How do second-order effects work? How does the economy tie back to valuation? What does inflation actually do and how? It’s all here.

Last December I started recording an audio explainer of the paper, but I lost steam. I really encourage you to read the original work but in the spirit of a parent who encourages abstinence but still hands their kid a condom, I’m going to hand over my notes. I spruced them up a bit to make up for their length. You can only reduce things so much. Enjoy:

  • Moontower Summary Of Jesse Livermore’s “Upside Down Markets” (Link)

If you’d like to hear Jesse’s interviews check:

  • Jesse with Jim O’Shaughnessy on the Infinite Loops podcast (Listen)
  • Short notes and interview about the paper (PodcastNotes)

Cassette Liner Nostlagia

The first cassettes I remember popping into a tape deck as a child were Paula Abdul’s Forever Your Girl and Madonna’s True Blue. My mom mostly listened to Arabic music from her youth, so I still don’t know why we had those two cassettes lying around in the rack with this thing:

I loved that tape deck. It had auto-reverse. Back then that was “living in the future”. In 5th grade, I started dubbing music from the radio. Funky Cold Medina and the Great White version of Once Bitten Twice Shy will date me if that stereo hasn’t already.

In middle school, I bought my first cassettes with my own money. Appetite For Destruction and GnR Lies. Latch-key living meant I could naughtily count all 13 F-bombs on Appetite while staring, terrified, at Robert William’s robot rape painting that censors relegated to the liner notes, leaving the iconic crucifix with Axl’s skeleton emblazoned on the center as the album cover. All before my mom got home of course.

If my mood is sentimental enough, I can still smell the record store I lived around the corner from. I remember all the scary heavy metal t-shirts. I remember the iron-on images of Twisted Sister and Iron Maiden displayed on the walls. Only when I grew up did I come to realize that the horror imagery was used by both saccharine and actual metal bands alike.

In high school, my tastes turned away from the arena rock tapes I frugally churned from Columbia House and BMG memberships. Now I was using any cash I could scrounge for CDs to feed my new Aiwa boombox and for Alice In Chains tees to signal my brooding angst captured by the dreary album, Dirt. (My half-cousin, 4 years older than me, who is a musician and author was a formative character in my growing love for music. He was full of theories and one that always stuck with me is how you can see each song on Dirt as a different way to die. It might have been astrology when he called Down In A Hole “death by sex” but it’s hard to listen to that album without his metaphors stuck in my head. It’s especially bleak since Layne and Starr both died young in the throes of addiction.)

Today, my taste in music is much more varied than my younger days when I would dump on any music without a sick lead guitarist as “talentless”. I miss the magic of ripping the plastic off a new jewel case, toggling repeat on the stereo, and burying my nose in the lyrics. It was not just novel. It felt dangerous. That’s not because of the music though. Now I know it was because it was freedom. The Walkman or the closed bedroom door didn’t require permission. Even better it was encouraged so I didn’t torture the rest of the house with all that noise.

I suspect the unavoidable chains of childhood led me to music which remains nothing short of wondrous to me. From a stripped-down beat to a symphony, the power to evoke is in my opinion one of life’s greatest gifts. That I can even receive that makes me grateful to be human.


Music discovery is different today. I don’t need to agonize over what album to buy with the limited cash I have. I don’t need to fret (pun very much intended) over wasting my money on a CD that was only going to have like 2 good songs. But without the risk, the reward can also be smaller. Music becomes just another thing we multi-task, not an activity of its own.

I try to resist that. I don’t watch TV shows or movies that much. I prefer music videos. I can be methodical about how I approach a new artist. Sure sometimes I just listen to the most popular songs listed on the artist’s Spotify but if you really want to peel the onion here are some approaches:

  • chronologically through albums (see how they evolve)
  • setlists (what they want to emphasize)
  • critic write-ups (curation method)
  • flowcharts (custom experience based on sounds you like)

I remember listening to an interview with Jack White (my thread on it), one of my favorite artists, about the state of music. He mentioned that the lack of gatekeepers has lowered the average quality of published music but also increased the quantity of what’s great. This is exactly what you would expect when the cost of creating and distributing music falls. On a technical note (the puns keep coming), studio time in the analog era was so expensive that the minimum bar for a musician was quite high, but this is counterbalanced today by the sheer volume of artists that you would never have accessed in that era.

I’ll leave you with a fun listicle by the prolific jazz artist and music writer Ted Gioia:

12 Predictions for the Future of Music (Link)

The always terrific Rick Beato did a reaction video addressing each of the 12 points bringing his immense knowledge of the music biz to bear on the predictions. (YouTube)


More Moontower music stuff:

  • Music Appreciation Channels (Link)
  • Moontower Public Playlists of Music And Videos (Link)
  • Posts about specific artists (Link)
  • The Middle 8 (YouTube Channel)