Newsflash: This letter’s audience has lots of professional and retail investors. There are also lots of aspiring traders or just people who want to supplement their income with “alpha” from the markets.

So I commonly get asked for advice on trading for oneself. “I have a $250k account I’ve studied A to Z…etc”

Many of the backstories are impressive. Y’all impress me. I got a non-rigorous econ degree that only required 8 core classes. And those catered to my strength — bullshitting on blue-lined pamphlets. I limp into a stellar firm that knows how to teach trading and decision-making just as it’s hiring its largest cohort ever. I’m a product of those I was lucky to be surrounded with. If I was good at anything it was assimilation. More practical than heroic ultimately.

So when a smart, bushy-tailed go-getter asks me about prospects for succeeding as a retail trader I’m torn. Trading is a hard way to make a living even when you’re sitting in the F-16 cockpit of a prop firm. Seems like it should be impossible for retail. On the other hand, I’m not built of the best stuff so who the heck am I to piss on the grit-factories that email me.

I got one of those emails on Monday. Sharing my responses(italics) here:

A few thoughts:

1. This thread from Lily is spot on

2. Listen to this interview with Darrin

Reader: What would your advice be to someone who loves markets and trading more than anything and doesn’t look at this as a chore, but rather a passion? Is it still a fool’s errand to not just DCA into QQQ and SPY and go find another interest?

Me:  99% of people should probably look elsewhere but that’s true of anything that is exceptionally hard. There still will always be the 1% who do not take no for an answer. Nobody can tell you who you are. You ultimately seize who you are. If you fall to the level of your weakest strength, you can still decide if that’s your resolve or something else.  

Reader: I know about all of the time in the market > timing the market, the Buffet bet, all of it – but maybe I am just irrationally stubborn?

Me: If you listened to the Will England interview you can hear him say that a lot of the neutrality guardrails are in place because nobody trusts anyone’s ability to time. Vol traders can’t even time vol and I’m talking about the best vol traders in the world. If this is what you think the edge is nobody is going to buy it. You will need to prove it with your own $. That said, timing is not really the edge most try to have. This interview might be helpful to expand your thoughts on it.

Reader: I guess I have seen some of my mentors trade very, very well, but maybe I am just not able to allocate as much time and attention via a full life elsewhere. Are there any resources you would recommend to explore further ideas? There are people way, way smarter than me that just say DCA into low cost interest ETFs and go take a walk, but is there anything worth anybody’s time when it comes to more active stuff?

Me: I didn’t up in this biz on my own like say Darrin did. I don’t know how those people do it, I can just listen to their stories. I’m pretty much in the camp of “get a job where you can do this full-time if you really want to”. If you can’t do this but still want to explore strategies, then fence out some capital to play/learn/experiment. For the rest of your assets stick with some kind of permanent portfolio implementation depending on your risk tolerance. You can follow folks like Corey Hoffstein, NomadicSamuel, Jason Buck, Lily for that stuff. InvestResolve guys too. All these tweet about it too and it’s all quite solid. I recommend this series by the InvestResolve team.

In general, my advice, which sounds hard but is probably easier than trying to trade for a living: get a high-paying job. 

All this focus on trying to make your money work for you is totally secondary to the biggest muscle movement — make more money with your skills or with a business. I came to the internet around 2015 to learn about investing because I already had a lot of savings, a house etc. So I was like “now what to do with the money”. Most of my option traders friends have no process or framework for investing. In fact, most of them find it to be a waste of time to give it a lot of thought. I don’t fully agree with them on that, but I was like that myself. Instead, we all focused on — “I want to make so much money that it doesn’t matter if I just stuck it in t-bills”. It’s a pretty jarring answer compared to conventional thinking and it’s not fully right — but there’s truth in the instinct.  When I look at people who have built more wealth in the past decade from investments than income I think — “that looks fragile”.

Everyone wants to feel like they slayed the investing dragon and were great at making their money work for them. Meanwhile, there’s a bunch of folks out there who want to focus on what they’re good at, have hobbies and be f’n happy on the weekends not researching the next investment or managing rental properties. They out there just thinking — I’m gonna go get paid seven figures a year on a W2 working for an elite organization.

I added this later in a tweet and it’s just straight talk if someone is sweating lots of financial success:

Be special enough to get pedigree

Or

Be special enough to not need pedigree

In other words, this reduces quite easily to things that are very hard. Invoking the “Why would it be otherwise” line.

And as far as being methodical about the original question of trying to earn a return on $250k, John has said it well:

One of my favorite writers,

just published an incisive climate posture post [paywalled]. It has this amazing passage that can be ported from climate contexts to people’s need to trade (bold is mine):

The narrative web of the climate discourse is very hard to map, but one thing is clear: Almost everybody is an NPC in the current situation, and is primarily desperately solving for how not to feel like an NPC. This is an important point. Humans have a strong tendency to confuse a psychologically satisfying amount of agency with a materially effective amount. A broad culture of what we very-online people call cope rules everything around us when it comes to climate. It is a deep-rooted tendency, and an understandable one. Much as we might intellectually desire such laudable goals as the survival of almost everybody through a planetary crisis, our sense of meaningful existence is tied to individual agency. We’d rather stride grim-faced with a gun across a devastated post-apocalyptic landscape, masters of our own fates, than feel helpless within a world that’s largely doing fine and even providing for us.

What. A. Line:

Humans have a strong tendency to confuse a psychologically satisfying amount of agency with a materially effective amount.

Don’t just stand there, do something, right?

But also…

A trader pinged me saying:

There is a false dichotomy between 100% passive and 100% active. I feel like with the right mindset/education/strategies, there are ways to meaningfully add value to one’s portfolio via lower touch strategies and this can be done in addition to one’s day job.

Like in the guys email, one of his first questions was whether it is a fool‘s errand to not just DCA into SPY. I feel like the investment education landscape is so distorted that DCA SPY is the baseline. I would almost argue it should be quite easy to outperform buy and hold, especially on a risk adjusted basis without having to spend hours of screen time.

Ultimately, questions like this are ones without tidy answers.

This is where I shake out on it for now:

My gut feel is return-stacking/permanent portfolio for long-term DCA is probably the efficient frontier of work/return/risk triple axis.

But there’s no doubt that many people want to put their hands on the wheel and that has innate personal value (and that’s true whether it’s misguided or not). So in short I think it’s a tree:

1. DCA permanent portfolio variant if you want autopilot
2. If you want to put your hands on the wheel what does that efficient frontier of effort/return/risk look like where return also includes some illegible component of DIY satisfaction?

This is related in a weird way but one of my favorite interviews was with Professor C. Thi Nguyen, author of Games: Agency As Art. It’s a penetrating twist of how art or creation is a form of agency — games allow players to take on different agency roles. To step outside themselves in a low-stakes way.

The pragmatic view of investing/trading is and should be for profit. But whether partitioning some of that mental and monetary budget to satisfy agency needs might say something about whether you are getting enough of that in other endeavors. Investment as agency?

I’ve been reading Ed Thorp’s autobiography with my 10-year-old (very slowly I might add — between myself and the boys we are simultaneously reading 5 books. Sympathies to Yinh who is surrounded by broken brains). We are about to start the second half of the book where Thorp leaves gambling (after the casinos tried to kill him by jamming his car’s accelerator!) and sets his sights on the world’s greatest casino — Wall Street. But despite being on the Mount Rushmore of investors, Ed left the game content to invest his fortune with other managers, seeing more to life than the day-to-day of this particular game.

An interesting side-note was Ed and Claude Shannon were good friends and accomplices in devising the world’s first wearable computer (which they used to break roulette). Claude was also a wildly successful investor. Both of these men saw investing as an interesting puzzle. Money was a byproduct. They didn’t seem to care too much about money other than its evidence of their hypothesis.

There’s a line in Tomorrow, and Tomorrow, and Tomorrow where celebrated video game designer describes a (less than mentally healthy) scene from his youth:

They were in her car on the way back from a math competition in San Diego, and Sam was giddy with the feeling of being better than everyone else at something that he didn’t care about at all.

I have several option trader friends who are misfits — amongst the smartest traders out there getting paid big bucks at the firms you know. They could care less about investing but find trading fun. This is just a game that pays way too much for what it requires of them. They have all these other nutty interests and would sooner off themselves than read an investing book. Me, I’m just a normie pragmatist. I did it for the money, not because I love the game. In fact, one of these friends has told me he thinks I’m totally f’n weird because I don’t love the trading part, I love the conceptual parts, the building parts — which is the exact opposite of his position.

My ability to pull any useful insight from this is strained. But it’s probably just some cliche — think deeply about what you’re good at and what you want…and the conversation that’s hardest to have with yourself — why do you want it? The answers are always laden with some amount of insecurity, but I think that’s what keeps us alive. And abolishing insecurity probably isn’t a reasonable or even respectable goal. Coming to agreeable terms with it strikes me as more human.

It must be nice to find that thing that’s in-demand that comes really easy to you. I wonder what an emphasis on finding that would look like rather than preaching the grit catechism.

There are lots of videos online of orca pods feasting on white sharks. What rattles the imagination is how they go straight for the liver. The liver’s bounty is a dense nutrient-rich oil called squalene that can account for up to a third of a shark’s weight.

Hopping over the semantic curiosity that benz and squal just adopt an “ene” to become oil words, I’ll skip straight to ruthless analogy. The pod shops in investing are top of the food chain in asset management. It’s said on the internet, so I know it’s true, that a single shark liver can nourish an orca for a “whole day”. First of all, if that’s supposed to be a jaw-dropping amount of nutrition call me underwhelmed. If a white shark a day keeps the doctor away, I’m left to think Shamu’s cursed appetite has no end — this is an aqua-treadmill of blood without a killswitch.

Which serves the analogy perfectly.

Squalene is alpha. There’s not a ton of it out there and the hunt for it mobilizes the top of the academic food chain. In 2000, I made $50k including signing and year-end bonus my first year out of college. That figure is 8x today for top grads accepting prop shop offers. Talent war.

The trading world’s ruthless focus on squalene — risk-adjusted returns while staying market-neutral to print money in any environment has been adopted by the investing world. And the allocators have noticed. The pods, like the orcas, are eating everyone’s lunch right out of their bellies. And those inflows are arming the war for mature talent too. Giant guarantees to proven managers. The kind of money that can get even the most ambitious manager to re-think starting their own firm.

With that intro, I’ll point you to a podcast:

Patrick O’Shaughnessy interviews Will England (Invest Like The Best)

Will is the CEO/CIO of Walleye’s $5B multi-manager hedge fund. I’m familiar with Walleye because they started in the mid-aughts as an option market maker. Several friends and ex-colleagues have traded for them. But this podcast is about their hedge fund, not the prop biz. It’s the best investing interview I’ve heard this year.

First of all, if you are unfamiliar with the multi-manager or “pod shop” pass-thru hedge fund model then this interview is a great primer. The big 4 managers in the space are Citadel, Balyasny, Millenium and Point 72.

Will’s language, tone, and thinking will be deeply familiar to folks who have done tours of duty at prop trading and option firms. My take on this interview is “damn, that was honest”. Will is in Minnesota but shoots as straight as a Chicago pit trader. Heck, he addressed the alignment issues with the “back book” — I’ve talked to pod traders about this idea before and couldn’t believe he broached the topic in this call). His voice was like a lullaby from my younger years.

Patrick asks the right questions. Everything from the knowledge to the story is worth an hour of your time. It confirmed a lot of what I thought I knew and taught me even more.

A few thoughts of my own

Will says 25% of their business is still options trading but a significant chunk is now fundamental equity. The PMs are trying to earn a 3% spread between longs and shorts after stripping away beta and factor tilts. Just like other pod shops, these guys are farming pure alpha or “idio” (for idiosyncratic) and levering it to get to about a 30% return which the investor hopes to see half of after implicit/explicit fees.

It has always struck me that this is the natural progression of active management. A barbell where you pay up for pure alpha and get your beta for free.

The closet beta active management world is a melting ice cube. But the incentives and stickiness of legacy relationships both from allocators and story-telling managers will try to keep the freezer door closed as long as possible.

But I can’t say I know where the equilibrium will shake out. If you have pure alpha, you can choose your investors either by fees or by preference. You have all the bargaining power. But I’m not sure what the capacity of alpha even is. Will didn’t mince words about the competitiveness. He thinks the number of PMs that possess both the chops and psychological profile to play this game is on the order of a thousand people maybe. The pods are flush with cash and signing talent with big upfront deals like athletes. (He admit the model could be in a period of froth at the moment). Will’s belief in market efficiency sounds like “efficiently efficient”. Yes, there are 10 Sharpe strategies. They are also low-capacity. Any strategy with an obnoxiously high Sharpes is basically arbitrage counting down to extinction. But that new species pop up and then disappear is a general truism. A never-ending game of whack-a-mole.

[Aside: Anyone reading Moontower for a long time knows I don’t wade into the market-efficiency debates because they sound like academic masturbation. I have my own version which rhymes with what Will talks about — The “No Easy Trades” Principle. When I encounter someone who disagrees with this I hear one of these possible confessions:

1. “I got rich on a highly concentrated risky bet and have never considered what the outcomes would be if I re-ran my life 100x”
2. “I have no idea what I’m talking about”

I was out with a friend recently who ran a high-volume options trading business for 25 years. We talked about how nearly every time they would “exploit” some weird rev/con financing opportunity they found a way to get f’d by the borrow market. He could rattle off example after example of interesting set-ups and yet the outcomes were consistent. You’re literally paying to discover new failure modes but the way each setup arrives you feel like you can see why the opportunities are real.

Almost every time I did a trade and felt good about it afterward, I was in the pre-glow of a bad beat. The trades that feel scary are the ones that pay. And this makes sense — the price is compensation for doing what nobody wants to do. The job-to-be-done is finding a way to manage the risk until everyone who is transacting to satisfy their greed or pain is filled. The removal of that pressure is what begins to turn the trade in your favor.

Trading profitably is painful. It must be or there is no reason to be paid for it. what’s worse — just because you feel pain, doesn’t mean you will make money. The pain is the cherry on top of doing everything right. You can have pain even if you do things wrong and it will be in vain. The difference is when you do things wrong, you feel good about it in the interim because you don’t get how this works. And that fleeting satisfaction is what keeps you from learning.

I’m sorry but trading profitably means being constantly paranoid and finding a way to live with that. I suspect a subtle aspect of what makes the pods so smart is they have codified and automated the risk management in a way that guarantees the PM’s paranoia.

This is an aside because I think you need a lot of reps to grok what I’m saying and honestly most people will just go on pointing to things that don’t make sense and breathlessly exclaim “See the market is inefficient”. You don’t have a right to say that unless you tweet it from your yacht purchased with lots of receipts.

Strategically, in a game where the skill level is extremely high and evenly matched, then variance will drive a lot of the separation. So the counterintuitive response for someone dead-set on being rich but knows they are overmatched is to take a giant, high-variance bet and hope this was the lifetime it panned out.]

Sorry, back to the body.

In short, I don’t consider what these pods are doing to be investing. They are trading but on a medium time horizon. It’s called “fundamental equity” but let’s say the holding periods are under 2 years and probably more like 1 (if someone knows the stats please share) then this isn’t about “realized” fundamentals. This is about anticipating change in sentiment around expected fundamentals. This feels like a game of nearer-term info, flows, positioning, and game theory. A re-rating game. A game that was much more similar to what I did (although it sounds more complex than vol trading which has more to do with flows and is yet even smaller capacity) than what I imagine value investors do.

My thoughts on value investing are mixed. And I’m being liberal with the word “value”, recognizing that cookie-cutter implementations of “value” are the equivalent of accounting fails (like not updating the meta-principles to handle object-level changes in importance to things like goodwill or brand equity). I assume there are value managers who can spot high-multiple value names because they have a “g” column in their Pandas dataframe (just kidding — I meant in their spreadsheet — we are still talking about value investors here). The problem with these managers and their “long-term” theses is they want you to buy the brand name vitamin instead of the generic and when you ask for the quarterly bloodwork to see if it’s making a difference they say you won’t see the benefits until you retire. The blood results are just “noise” they’ll tell you.

On the other hand, if the manager’s signal reliably swamped the noise then they wouldn’t give that away. They’d try to get pod shop fees. Market efficiency is fractal — there’s a market for the assets and for the labor that moves the assets. I’ve alluded to this before in The Paradox of Provable Alpha and Will’s interview made me think it’s only going to be a more relevant paradox going forward.

Learn more:

🧵BEAT THE PODS: A 7-POINT RECIPE FOR SINGLE MANAGERS (Brett Caughran)

This is a long but good thread by @FundamentEdge

This pairs well with Ted Seides’ interview with Jason Daniel and Porter Collins, 2 of the investors made famous in The Big Short from their work with Steve Eisman:

🎙️Big Shorts and Big Longs (Capital Allocators)

These guys had a stint at Citadel where they learned the intricacies of the pod model. It didn’t resonate with them and for reasons that confirm my own interpretation — pods are more like traders than long-term investors. They had 2 big insights:

1. The pod model is so prevalent (and it is smart) that if you don’t understand the dynamics they impose on the market, you’re playing with one eye closed. They have respect for the model (and how Citadel implemented it) even if it’s not their game.
2. They realized the model left some forms of edge behind because of its nature. They could make picking that up part of their own niche. This is touched upon in Caughran’s thread above.

🔗Multi-Manager/Pod/Hedge Fund 101 (7 min read)

Byrne Hobart’s primer from his evergreen Capital Gains Substack

My biz partner friend is way more of a math guy than me. If you want to be a trader you’ll get more mileage studying gambling than investing. Although I’ve done some study of gambling, it’s nothing compared to my friend’s info diet. He’s been a giant sports analytics nerd for the past 20 years (one day I might share a story of his meeting with an NFL team owner. I get stressed thinking about it, so can’t imagine how my buddy feels).

I asked him for some book recs in the vein of Scorecasting written by AQR quant Tobias Moskowitz (you may remember me recommending his children’s novel Rookie Bookie).

The list:

• Baseball Between the Numbers: Why Everything You Know About the Game Is Wrong
• The Book: Playing the Percentages in Baseball
• Seminal: Bill James
• Win Shares
• Basketball on Paper: Rules and Tools for Performance Analysis
• The Expected Goals Philosophy: A Game-Changing Way of Analysing Football
• The Hidden Game of Football: A Revolutionary Approach to the Game and Its Statistics

Finally, my internet friend Andrew is an independent trader who came out of the sports gambling world. I’ve spoken to him several times. Very smart, you should follow him and check out the sports modeling books he’s written:

• Andrew Mack

Some recent convos had sex with lingering thoughts from a podcast on a bed of a blank page this morning and today’s Moontower is the weird baby that popped out.

I recently listened to my first episode of Dan Carlin’s Hardcore History — a tour of the transatlantic slave trade entitled: Human Resources. Dan’s story-telling and research shine in this nearly 6-hour episode. He deserves all the accolades he gets. The style, quality and nuance of his work are well-advertised, I’m just late to the party. He immediately jumped into my ring of favorite creators.

I’m also a fan of the Founder’s podcast. Because I found an interview with its host David Senra to be as compelling if not more than the books he highlights (a high bar), I decided to hunt down interviews with Carlin. The first one I clicked on with Lex Friedman did not disappoint.

• 3+ hour interview (Lex Friedman on YouTube)

Here are 4 excerpts that stood out to me, but the whole interview is good.

https://moontowermeta.com/a-few-excerpts-from-dan-carlin-on-lex-friedman/

I’ll post one of the excerpts here because I like Carlin’s approach — he answers the question probabilistically (and his gambling mindset in general to handicapping answers is prevalent in the way he reasons) but explains the framework he is adopting to approach the question.

[Meta observation: Answers to questions often fall out trivially from the model you choose to approach it, so it’s a reminder that your choice of model in the first place is critical — any ensuing logic will unconsciously inherit its assumptions. The work of overriding assumptions to adjust for differences between the reference model and the question at hand is where devilish details lie. But when encountering an argument, it’s a good idea to question the choice of model before quibbling over details.]

On to the excerpt:

Lex asks how we will “destroy ourselves”. Carlin gives a framework for handicapping what calamity will undo us.

Lex: If you were to wager on the method in which human civilization collapses, rendering the result unrecognizable as progress, what would be your prediction? Nuclear weapons? A societal breakdown through traditional war? Engineered pandemics, nanotechnology, artificial intelligence, or something we haven’t anticipated? Do you perceive a way humans might self-destruct or might we endure indefinitely?

Dan’s response (emphasis mine):

My perspective is primarily influenced by our ability to unite and focus collectively. This informs my estimates of the likelihood of one outcome versus another.

Consider the ’62 Cuban missile crisis. We faced the potential of nuclear war head-on. That, in my view, is a hopeful moment. It was one of the few instances in our history where nuclear war seemed almost certain. Now, I’m no ardent Kennedy admirer, despite growing up during a time when he was almost revered, especially among Democrats. However, I believe John F. Kennedy, acting alone, likely made decisions that spared the lives of over a hundred million people, countering those around him who preferred the path leading to disaster.

Reviewing that now, a betting person would have predicted otherwise. This rarity underpins our discussions about the world’s end. The power to prevent catastrophe was in the hands of a single individual, rather than a collective.

I trust people at an individual level, but when we unite, we often resemble a herd, degrading to the lowest common denominator. This situation allowed the high ethical principles of one human to dictate the course of events.

When we must act collectively, I become more pessimistic. Consider our treatment of the planet. Our discussions predominantly center around climate change, which I believe is too narrow a focus. I become frustrated when we debate whether it’s occurring and if humans are responsible. Just consider the trash. Disregard climate for a moment; we’re harming the planet simply through neglect. Making the necessary changes to rectify this would necessitate collective sacrifice, requiring a significant consensus. If we need around eighty-five percent agreement worldwide, the task becomes daunting. It’s no longer about one person like John F. Kennedy making a single decisive move. Therefore, from a betting perspective, this seems the most likely scenario for our downfall as it demands a massive collective action.

Current systems may not even be in place to manage this. We would need the cooperation of intergovernmental bodies, now largely discredited, and the national interests of individual countries would need to be overridden. The myriad elements that need to align in a short span of time, where we don’t have centuries to devise solutions, make this scenario the most probable simply because the measures we would need to undertake to avoid it appear the least likely.”

[a later thread that rounds out his thinking on this]

“Returning to our primitive instincts, we are conditioned to address immediate and overwhelming threats. I hold a considerable amount of faith in humanity’s response to imminent danger. If we were facing a cataclysmic event such as a planet-threatening explosion, I believe humanity could muster the necessary strength, empower the right individuals, and make the required sacrifices. However, it’s environmental pollution and climate change that pose a different challenge.

What makes these threats particularly insidious is their slow development. They defy our innate fight or flight mechanisms and contradict our ability to confront immediate dangers. Addressing these problems requires a level of foresight. While some individuals can handle this, the majority are more concerned, understandably so, about immediate threats rather than those looming for the next generation.

Could we engage in a nuclear war? Absolutely. However, there’s sufficient inertia against this due to people’s instinctive understanding. If I, as India, decide to launch an attack against China, it’s clear that we will have 50 million casualties tomorrow. If we suggest that the entire planet’s population could be extinguished in three generations if we don’t act now, the evolutionary trajectory of our species might hinder our response.”

The remaining excerpts cover:

• An example of how propaganda can scramble your beliefs in a way that creates collective distortions that are hard to see
• The problem with dictators or strongmen even if they are wise and benevolent
• Will the US tear itself apart in a second civil war?

[Note: I used GPT-4 to clean up sections of this transcript: https://www.happyscribe.com/public/lex-fridman-podcast-artificial-intelligence-ai/136-dan-carlin-hardcore-history]

Money Angle

Here’s a stream of consciousness reflecting on a few recent private convos jambalayed with some of Dan Carlin’s thoughts.

I was hanging out with a good buddy (and former biz partner) and talking shop a bit about the options biz. I’ve heard about how implied correlation is “trading in the 0th percentile” but that selling it continues to be profitable in 2023 because it’s “realizing” even less than implied (to be clear he runs a big strategy and we don’t discuss what he does so there is no suggestion that he is also doing this. He merely confirmed that implied corr was historically low). This reminded me of the misery that was 2017, where the best trade would have been to just lay into single-digit SPX vol because realized vol was so low you’d wonder if the stock market even opened anymore. The opening bell rings and you immediately ask “What’s for lunch?”.

While we were walking around Ghirardelli Square, my boy made a throwaway comment that my mind hasn’t emptied from the trash.

The hard leg is always where the money is.

I thought about how, in 2021, the dumbest possible idea — buying a dog coin — was the best trade at one point and shorting it was too at a different point. But both were hard at the ripest times to do it and easiest when they were riskiest.

I thought about the double lot property I looked at this week with a realtor friend (the same one who sold both my house and my biz partner’s — if you are in the East Bay I’d be happy to intro. Good realtors are like good mechanics — gold amongst pyrite). There’s no math that makes the price of the homes make sense. Property in a specific location has little substitute and just trades like art. As my realtor properly diagnoses — “Kris, you’re like my lawyer father, you see the risk. But the people who win these auctions only see their family on a Christmas card”. This was not a knock on those people. As my friend Jared likes to say, their bank accounts have a phone number in them — I’ve seen enough behavior here to know that while folks aren’t Miami-flashy, a Ferrari is a rounding error sum of money in a home negotiation, not a decision. If you move from the Bay Area or NYC your bid would be obnoxious to the locals too.

It feels to me that everything is a momentum trade — selling dispersion at low levels, buying homes at 0 after-expense cap rates, having no top on what you’d pay for Harvard, hell, it’s an imperfect measure but even stock market earnings yield is less than t-bills.

It’s all momentum until some grand event makes it abundantly clear that the world has changed. Then you get the situation currently embodied in the no-bid CRE markets of say SF and Chicago.

Liquidity is utterly discontinuous in such a world. Value will become increasingly resistant to traditional measurement because there is so much wealth in search of a return you can reason that any opportunity where the math makes in a textbook spreadsheet, the value is sitting on a landmine, already passed on by the infinitely patient family offices of moguls who are not forced to chase LP-friendly payoff diagrams.

I chatted this week with another good friend who finds and stacks strategies at a well-known pod shop. He talked about a trend he had seen in motion much earlier — the accelerating difficulty in finding talent/alpha. He’s impressed at the speed at which the market for alpha is getting efficient but this is what you’d expect when pods are eating the investment world. Millenium manages $50B that is laser-focused on uncorrelated skill (grapevine tells me they increased how many pods that trade dispersion in recent years — cue the “markets are biology not physics” analogy — which means the marginal bid for single stock vol has increased. This actually means the environment for covered call selling might be unusually nice. This doesn’t contradict my broad admonitions about call-selling. It actually makes my point — that you should be discerning about the practice and not think of it as passive income or free money but understand what circumstances make the strategy more or less ripe.)

All of this makes me wonder about the distribution of investment outcomes in aggregate. Suppose the underlying economy is steady. Does the median return increase at the expense of the left tail (keeping the expectancy the same)? In a world where capital is more easily deployed and more concentrated, what happens to the shape of returns?

Look at the deal the Saudis have offered Mbappé or their pot-splashing with LIV golf. It all feels related. Financialization, private-equityization, Softbankization. Increasing rewards for capturing attention (see athletes or Cathie Wood). The internalization of rage bait as a social media strategy. Twitter X is rapidly being consumed by engagement tactics (dystopian thought: this trains people to be numb as they will eventually adopt defenses against engagement until we lose the ability to know what we should pay attention to). The harder profit is to find the greater the temptation to cut another forest down. We are great at identifying growth. Less great at understanding its costs. Wouldn’t be a bad tagline for America if taglines were honest.

(In Dan Carlin’s slavery pod I felt that the moral concerns didn’t gain steam until the cost of enslaving Africans became more apparent. You know that expression “narrative follows price”? Maybe we don’t moralize until a loathsome but profitable practice reaches its blood-from-a-stone phase and the cost of moralizing is lower. If you try on that perceptive for a day you’ll either want to claw your eyes out or you’ve already sold humanity to zero.]

All of this echoes Dan Carlin’s suspicion that our undoing will be collective action problems. If you believe that the logic of efficient markets (a collective action coordination mechanism that differs from democracy) is playing itself out in a rules landscape that has significant divergences from the political question of “what is good for broad-based flourishing”? You could imagine capitalism resting on many different types of rule frameworks. But you’d also expect the ruling framework, the one called a “free market”, to be shaped by its victors (corporations are people too, right?).

To Carlin again — propaganda can scramble your beliefs in a way that creates collective distortions that are hard to see

[Carlin is a war historian and while he admits to his bias towards individualistic ideals “I’m famously one of those people who buys into the ideas of traditional Americanism”, his characteristic nuance is well-displayed in his deep skepticism of the “military-industrial complex” and how its inclination towards self-preservation as an institution often exerts undue influence in when America looks at its menu of choices]

“Many people living today seem to think that patriotism requires a belief in a strong military and all the features we have in the present. However, this is a departure from traditional Americanism, which viewed such elements with suspicion during the first hundred years of the republic. They saw them as foes to the very values that Americans celebrated. The question arises, how could freedom, liberty, and individualistic expression thrive with an overarching military always engaged in warfare?

The founders of this country examined examples such as Europe and concluded that standing militaries or armies were the enemy of liberty. Today, we have a standing army deeply woven into our society. If one could go back in time and converse with John Quincy Adams, an early president of the United States, and reveal our current situation, he would likely find it terrible and dreadful.

Somewhere in our history, Americans seemed to have strayed from their path and forgotten their founding principles. We have successfully combined the modern military-industrial complex with the traditional benefits of the American system and ideology, so much so that they have become entangled in our thought process. Just one hundred and fifty years ago, they were seen as polar opposites and a threat to each other. When discussions arise about the love of the nation, I harbor suspicion towards such sentiments.

I am wary of government and strive hard not to fall prey to manipulation. I perceive a substantial part of what they do as manipulation and propaganda. Therefore, I believe a healthy skepticism of the nation-state aligns perfectly with traditional Americanism.”

I’ll leave you with a thought — let’s do an analogy substitution.

What if the version of capitalism we endure today is the military-industrial complex and Georgism is actually more aligned with the meritocratic principles this country is supposedly based on?

I was running a few car errands yesterday thinking and my mind wandered onto a particular anxiety — why inflation is so psychologically upsetting.

[If you’re a well-adjusted person you don’t have such thoughts pop in your head while you’re pulling into Ace Hardware so count yourself among the lucky. But part of opening this email is you get some of my brainworms. Turns out nothing is free, including free newsletters.]

Inflation is obviously distressing because nobody wants to run faster to stay in the same place which is what you must do if your costs outpace your income. But inflation, especially sit-on-our-ass symbol manipulators like myself (and probably many of you reading a Substack on your work computer), awakens a fear that otherwise just harmlessly beeps in my subliminal background processes — the recognition that my pleasant, modern life is built on abstraction.

And there’s one abstraction in particular that I want to rub the invisible ink decoder on to expose — the economic principle of specialization. Modernity has so fully internalized this principle that we take for granted that the crops will grow and trees will be dragged from the forests for milling. This assumption allows us to focus on whatever our own crafts are knowing that we can convert the products of those efforts into money which we can exchange for food.

Inflation is a giant monkeywrench in the exchange rate between our craft and all the others we rely on to make it through breakfast without major surprises. The invisible solutions become revealed for what they are — assumptions.

I’m not sounding any alarms — specialization and its logical cousin comparative advantage are formidable foundations for flourishing and prosperity. I’m only pointing out how inflation causes you to notice the assumptions and that feels like someone asking me “do you know what’s in that?” as I bite into a hot dog.

In Pathless Path, Paul Millerd writes:

In the 1970s, academic turned farmer Wendell Berry wrote about how economic success includes the hidden cost of depriving people “of any independent access to the staples of life: clothing, shelter, food, even water.” What was once the riches of self‑reliance have become things with a price.

Tim Wu made this point in a widely read essay titled “The Tyranny of Convenience,” where he argues that convenience, “with its promise of smooth, effortless efficiency…threatens to erase the sort of struggles and challenges that help give meaning to life.” Wu argues that many see convenience as a form of liberation. People aim for “financial independence” only to realize when they achieve it that they’re only independent in the narrow sense of being able to pay for everything.

I have anxiety about my distance from self-reliance. I’m not handy, I have a black thumb, and I tolerate prepping food (I can’t call what I do “cooking”). I have a profound sense that if we were born in another era or place my life would be somewhere between “less pleasant” and “brutal”.

I often think about this interview response by hedge fund manager and one of the greatest Magic The Gathering players of all time, Jon Finkel:

I think I’m a bright guy, but I’m also aware of how much of my success has been luck. I was born a white man to upper middle class parents in the wealthiest country the world has ever known. I had a very specific set of skills that are easily translatable into money in our current society, but would have been far less useful for most of human history. The game I got obsessed with happened to grow and expand into the enormous thing magic has become, and it just so happens that I was actually good at it. So basically, I don’t think I have an edge in everything at all. I think I had a couple specific intellectual skills and it just so happens that they’re most obvious in the games that all the smart people I know also play, so it makes me look more talented than I really am.

We are short a far out-of-the-money put struck at self-reliance that’s denominated in fiat currency. The premium of that put start showing up on the End of Day Risk Report when inflation rates accelerate.

With all this said, I also hold tremendous sympathy for those who might be self-reliant but haven’t proportionally benefitted from financialization (the symbol manipulation industries of tech and finance are the lions closest to that carcass). They might be long the teeny-delta return-to-primitive put, but they are also short a straddle near the meat of the distribution. Moderate upticks in inflation that outpace income, create a similar anxiety — it erodes the stored value of their prior work known as savings. But they might have the extra disadvantage of being under-educated in the abstractions of money and investing. Symbol manipulators will have more confidence in their ability to mitigate inflation by investing in value-producing ventures.

[Note that “value-producing” is irrespective of currency — if you care for children, no matter what happens to the world, there’s going to be an exhange rate for what the work is worth relative to something else of tangible value. Nannies make 40 bananas an hour regardless of what the inflation rate of USD says].

A few nights ago I was chatting with my mom.

My mom is a smart lady. She taught me how mortgages worked when I was in elementary school. I was fortunate to be born to someone who taught me about money, savings, interest and loans.

But she doesn’t understand investing.

She didn’t understand dividends until Sunday. She didn’t understand the source of return for a business or the idea that a business owner is a “capital allocator” and how they must choose what to do with their profits from a menu that includes:

• giving money back to investors which can be done through:
  • dividends
  • buybacks
• re-investment back into the business
• mergers and acquisitions

What they choose to do is a revealing action. It signals what they may think of the company’s health or foreseeable prospects.

So even if I have the standard anxiety about inflation plus some personal insecurity issues that it stirs about self-reliance, they are low-grade neuroticism around extremely remote events like hyperinflation.

I feel for the average American who I’d bet is even less informed than my mom.

[I shared this thought with the local social club I’m in and there was plenty of interest in basic personal finance talks, so I’m collaborating with a few members to do some firesides at the club.]

Look, I understand the arguments for moving from defined benefit (ie pensions) to defined contribution (ie 401k) plans but “democratizing investment choice” without the proper scaffolding feels like an invitation to have the wolves educate the sheep.

I’m capable and enjoy helping people think better about this stuff so I’ll keep on. But just a reminder, that if you feel comfortable with investing basics (and most of this readership does!) don’t take it for granted that your neighbors do too. A nice way to give back locally or just in your family might be to organize a session where no question is too basic. Create a no-judgement zone. You, right now, are sitting there with the skills to alleviate some of your friends and family’s anxiety.

In return, I’m sure they’d love to help you navigate an Ace Hardware.

Warning: You should probably turn back now. This one is a beast.

Something feels broken in our society

The US is the most prosperous nation on Earth. But it feels unnecessarily unbalanced.

2 observations stand out to me:

1. Labor share of the economy has fallen sharply behind capital’s. Wages have significantly lagged asset prices which has had massive distributional effects.
2. The distributional effects:
   1. 70% of US wealth is held by the top 10% (via Fed)
   2. This top-heaviness is driven then reinforced by the reality that more than 50% of the income is earned by the top 20% whose savings are directed to accumulating wealth via investment.

[See Upside Down Markets for a fuller discussion of these effects]

These observations are unsettling.

We have a progressive tax code yet the winners seem to be accumulating advantages faster than redistribution can hold the center. Whether labor has lost bargaining power (ie globalism), or the inherent leverage in technology allows gains to be concentrated amongst fewer owners, or whatever the reasons are it is clear that imbalances are building. And if the flow variable (income) is unbalanced, then redistribution is really just delaying the inevitable swallowing of the stock variable (US wealth) by the few.

I have likened the current environment to the endgame of Monopoly.

[I’m actually quite tedious on this point]

My concerns about inequality stem partially from a sense of Rawlsian justice (see “veil of ignorance”) and partially from a desire for cohesion. The wider the gap between people, the less overlap they have in their concerns. This has as much to do with social fabric as it does with justice.

I think there are many wealthy people who recognize this and would be willing to sacrifice in the name of the collective (there are lots of rich lefties who will vote against their own narrow financial self-interest). But it’s a prisoner’s dilemma. Nobody wants to be the only confessor.

I find myself at an impasse as I think through the inequality/cohesion problem.

On the one hand, I’m philosophically aligned with large estate taxes and lower thresholds and steeper graduated tax rates.

But my sympathy remains philosophical only. I cop out when it’s time to actually push for these things in the real world and not just on a blog.

There are 2 reasons.

1. The government, owned by corporate interests as it is, would probably leave me feeling like I sacrificed in vain. I’ll admit this sounds like a grand Zerohedgy, illuminati-phobia. But it’s more of a general unease with power and its corrupting influence. I don’t believe in either benevolent dictators or moral fortitude at the level of institutions. And in this case, we would be giving the institution of government even more power because of the next reason which is more important than the first.

2. Any additional large sources of taxation should not be simply bolted on. The layers of pork and exceptions in our complex tax code require a re-thinking. Unfortunately, they are so load-bearing on society’s investors’ expectations that I don’t think it’s possible to overhaul them. Being incremental just means more taxes without addressing what’s fundamentally broken.

Which begs the question through all this haze…what is fundamentally broken?

This is a zillion-dollar question to which a single answer would discredit the respondent who fell for such a framing. But living in CA, I think I see a clue.

The California Clue

I love living in CA despite its fiscal framework. CA is what you’d get if you told Wario to design public finance. Let me get this straight… a young worker with a good job will pay nearly 50% in combined Federal and State taxes, while an absentee landlord living in Orange County has plenty of time (the app he uses to collect the rent is built by the young worker, by the way, saving the landlord the indignity of paperwork and trips to the local Wells Fargo branch) to scream at “lazy bums” to pick themselves up by their bootstraps, all without a shred of self-awareness about his grandparents’ fortunate decision to buy a regular house in Newport that’s now worth 8 figures and is protected by Prop 13 from high carrying costs?

My mother bought a house in NJ for $70k in 1982. It has appreciated 5x for about a 4% CAGR. She paid 2% property taxes reassessed every year. In real terms, she lost money. But she had a roof over her head.

An equivalent house in CA cost about the same in 1982. I know because she and her father tried to move us to the Bay Area 40+ years ago. They couldn’t find jobs out west, so I was raised in NJ. You could have thrown $70k at nearly any house in the Bay Area in 1982, and it’s worth seven figures today. And the property taxes can be safely rounded to zero because of Prop 13.

In CA, the reward for getting lucky once was to get to stay lucky. In other words a landed gentry. Meanwhile, family formation in Bay Area suburbs is limited to Millennials or Zoomers who will inherit their parents’ homes and that sweet stepped-up basis. The ladder is officially pulled up. The rentier is on top while the worker falls behind on the treadmill down below.

CA’s fiscal dysfunction likely has many causes. But the output is plain to see — it’s a state that gives preference to building wealth through capital appreciation instead of labor and the real estate market has internalized that logic. But real estate, in particular, land should be considered a reserved word to use a coding analogy. Thinking land is just another form of capital, like a computer or factory is a subtle but profound error.

To understand why, we resurrect late 1800s economist and philosopher, Henry George.

The Journey

Taking the role of docent, I’ll soon hand you a map of the learning journey I took myself and let you begin a self-guided tour.

Before pointing out features of interest, a personal thought:

As a parent looking at…

• exploding college costs,
• the Hunger Games of achievement and admissions,
• and scandals where well-resourced celebs take giant risks to bribe their kids into higher ed,

…I see dead people fear.

Pair this with anecdotal observations of more people obsessed with “generational wealth” or becoming a “family office” (my friends Jason and Corey puzzled over this as well and apparently it triggered a bunch of listeners!)…and I think I either see the common thread or I am just projecting:

Successful people, either self-aware of the role of luck in their fortune or not, sense what I sense — the ladder is pulled up.

I live in a nice Bay Area suburb. Re-run my life 100x from my starting conditions and I get here in maybe 5 of them. My kids, without help (either by inheritance AND me footing the bill for college), have almost zero chance of one day being able to afford living here — and I’m not living in luxury. I rent an old house that hasn’t been updated in 40 years that sits on valuable land. It’s worth more than $2mm. It will be torn down by the next owner.

That recognition makes many people who on paper look they’ve “made it”, feel insecure because they see how cold it is out there and they worry for their kids. The left tail of outcomes looks dreary in America. And if you are doing well but not “financially free” that left tail starts in the next town over where the schools are ranked a 3.

[Aside: “Financial freedom” — just jab me in the eye with a Bottega keychain — I f’n hate these words. I just had dinner with a friend who works in a personal setting with billionaires — they don’t sound free in any meaningful sense of the word. Money doesn’t unbreak your brain. No matter how much you got you still gotta live with that thing. If you have the luxury of reading a substack, a lot of what you think you want could be achieved right now when you acknowledge that what’s holding you down isn’t material. Every one of you knows rich people who are slaves and average people whose hearts soar. Maybe take the clue seriously. Follow some breadcrumbs.]

Back to this Henry George journey.

That sense that the ladder is pulled up, that sense that the American prosperity that we can plainly see on a Wikipedia ranking feels somehow more distant when we try to shave off a bit for our own security creates dissonance. “I know the facts say we’re alright, but I don’t feel we’re alright.”

George gave me a provocative perspective. He predicted a paradox of poverty being chained to progress. Just as a back or knee problem can be caused by weak core, in a system as complex as the body or an economy, the root of an unbalance can feel unrelated. George put his finger on something I had felt but never was able to articulate — treating land as just another form of capital is a profound and fundamental mistake.

It is a bold argument when he proclaims:

the resilience of poverty, oppression, and inequality in the face of advancing economic development is not some embarrassing accident we’ll eventually get around to fixing, it’s an inescapable consequence of our socioeconomic system.

His ensuing argument was a lightbulb moment for me. Land deserves a special place in our financial framework because its supply is fixed and it’s a “monopoly of nature”. We cannot understate the extent to which this breaks much of the economic thinking we are accustomed to.

If you treat land the same way you would a bar of pig iron, an hour of work, or a dollar bill, before you know it you’ll get poverty paradoxically advancing alongside progress, inexplicable bouts of industrial depression, literal genocides and holocausts (he’s dead serious about this), and The Rent Being Too Damn High.

The analysis will build a familiar economics framework from first principles but what stands out to me is how important it is to account for land correctly. It’s as revolutionary a measuring insight as Sabermetrics and Moneyball was to sports.

Your journey to being “George-pilled” is not meant to be a religious conversion. Approach it as mind-expansion. It’s a very fun tour.

I have re-factored Georgist expert Lars Doucet’s review of Henry George’s Progress & Poverty with my own commentary. The links are at the end of the post.

The path you’ll find before you:

1. Define termsGeorge insists sloppy terminology leads to sloppy thinking. Naturally, he spends an entire chapter beating words to death to correct this.
2. Address the central questionWhy, in spite of increase in productive power, do wages tend to a minimum which will give but a bare living?
   
3. Define the “laws of distribution”When society produces wealth, who gets different shares of it, and why?
   
4. Put it all together into a framework that properly reflects economic realities and justificationsKris: George’s commitment to proper return attribution warms my heart. One of the most difficult aspects of performance evaluation in trading/investing is decomposing luck from skill. In the ideal framework, you’d want to extract all the return that is not due to “beta” which is cheap exposure to acquire. You want to identify idiosyncratic skill/alpha/edge. By isolating the components of return we are more capable of assigning prices we are willing to pay for those idiosyncratic and often “uncorrelated” sources of return. George was a stickler for creating an accounting paradigm that actually represented reality. Thus represented, we can have meaningful discussions about the trade-offs of policy and outcomes just as accrual accounting gives a better representation than cash accounting for a business’ opportunities and challenges.
   
5. The remedy Make land common property!

   
   He doesn’t want to confiscate land, or force everyone to live on some giant hippie commune. He proposes instead to let everyone continue to “own” land exactly as they do now, but we should impose a special tax to neutralize the perverse incentives of land rent. He anticipates a lot of pushback on this, and promises that his remedy is just, can be practically applied, and will actually solve our problems.

   Kris: It’s important and worthwhile to read the above arguments, counters, and justifications. But the key point, in my opinion, is a land value tax is not happening in isolation. This tax would be in lieu of many existing taxes and in fact I think taxes on the commons are preferable to taxes on income. In fact, George’s followers are often referred to as “single taxers”.

Final comments before I give you the keys.

1) I didn’t know there was a single tax movement (except the regressive “flat taxers”.) I’m conceptually aligned with wealth and large estate taxes instead of income taxes but for practical reasons (collections, loopholes, corrupt government power) I don’t push those ideas. George’s idea of a land value tax strikes me as a more promising response to imbalances that provoke me in the first place.

2) Our failure to account for the role of land properly (specifically by treating it as equivalent to other forms of capital as opposed to a fixed, inelastic supply granted by nature) leads to a host of economic distortions. But the most critical is causes us to conflate monopoly with capitalism. George’s case is not against capitalism. He’s against substituting human monopoly for nature’s monopoly because we fail to do proper attribution of factors of production and their respective returns.

This is a giant error. To quote the review’s author Lars Doucet:

People are now paying 50% of their income just for rent. And that’s not sustainable in the long term. The cycle you have there is revolution. I’m not kidding.

Look through history, you either have land reform or you have revolution. And you know, it’s, it’s either like either you have a never-ending cycle of, of, of transfers of income from the unlanded to the landed. Eventually the unlanded will not put up with that. You know, there was a real chance in the 19th century, at the end of the 19th century of America going full on socialist or communist and the only thing that saved us. It’s either Georgism or communism. And if you want to save capitalism and not go Totalitarian we need Georgism.

What George failed to anticipate was the automobile. And the automobile kicked the can down another couple generations. And it came at the cost of sprawl. And the cost of sprawl are enormous in terms of pollution and poor land use.

But now we’ve come at the end of that frontier and now we’re at the same question. And it’s like, you see this resurgent interest in leftism in America and that’s not a coincidence. Because the “rent is too damn high”, poor people and young people feel shoved out of the promise and social contract that was given to their parents and they’re jealous of it and they’re wondering where it went.

3) Our misunderstanding of land leads to a misallocation of returns to capital vs labor

• We can’t see how treating land as capital (or a private “option”) perpetuates inequality as a) populations grow and b) as technology advances. This is spelled out in the tour.
• We suffer industrial depressions due to land speculation.The monkey wrench that causes the boom-bust cycle of industrial depressions is rent, and even though we have more than enough material wealth to provide for everybody’s needs, rent prevents us from distributing it fairly and equitably.

  Kris: Note that “equitably” has nothing to do with some moral justice as we are used to considering in classic tradeoffs between equality and efficiency.

  There is no tradeoff here!
  

  What we are seeing is that we do our accounting wrong and that much of the return we ascribe to capital is really just rent and as demonstrated needs to be treated differently.

You are ready to begin. Here’s the map:

1. The master document: On GeorgismThis is an outline and a container for links.
2. Moontower Refactors Lars Doucet’s Review of Progress & Poverty I’ve condensed and refactored the review while adding many of my own comments. The link to the original review is included and encouraged.
3. More from Lars Doucet Lars has devoted his life to nudging Georgist principles into reality, including building a startup devoted to using better technology and analytics to assess land and property.

   He’s written a book called Land Is A Big Deal and many articles on the web. But I want to highlight my first contact with Georgism — Lar’s interview with Dwarkesh Patel on the Lunar Society Podcast.

   You can find the interview, transcript, and my favorite excerpts here.

   If you are interested in this topic but don’t want to read the review, books, or my re-factored version this interview is the next best thing. Dwarkesh is prepared and does not pitch Lars softballs. It’s a challenging interview (although very much in a kind collegiate, spirit) that demonstrates Lars’ depth of knowledge. It’s very impressive Lars’ graciousness and open mind is exemplified by how he ends the interview:

   Thanks for grilling me. Thanks for all the hard questions. You know, I really, I really, I really like to be challenged in that way and like really engage with the best faith, hard-hitting critiques to make sure we like really understand what we’re talking about here. Because none of this matters unless it works. I’m not here to like defend Henry George’s honor. I’m here to like really explore whether this can actually be a solution to our problem.

   Personal favorite sections of the interview include:

   a) a practical discussion of what’s feasible to transition from our current tax code to a land value tax system including where in America and abroad it’s already being experimented with!

   b) The pitfalls of land monopolies in video games

   Lars has spent most of his career as a game developer. The conditions of land scarcity in games and the metaverse are profoundly insightful since they exist in a digital universe.

   20 years later, I checked back in [with Ultima Online]. And that housing crisis is still ongoing in that game. That housing crisis remains unsolved! You have this entire black market for housing. And then I noticed that that trend was repeated in other online games, like Final Fantasy 14. And then recently in 2022, with all this huge wave of crypto games, like Axie Infinity, Decentral Land and the Sandbox. Then Yuga Labs’ Bored Ape Yacht Club, the other side, had all these big land sales.
   

   At the time, I was working as an analyst for a video game consulting firm called Naavik. I told my employers we are going to see all the same problems happen. We are going to see virtual land speculation. They’re going to reproduce the conditions of housing crisis in the real world. And it’s going to be a disaster.
   

   I called it, and it turns out I was right. And we’ve now seen that whole cycle kind of work itself out. And it just kind of blew my mind that we could reproduce the problems of the real world so articulately in the virtual world without anyone trying to do it. It just happened. And that is kind of the actual connection between my background in game design and kind of getting George-pilled as the internet kids call it these days.
   

4. And finally…a fun bonus you’ll find in the master document, and the origin of Munchie’s title today:

   

It has been so fun to get “George-pilled”. Rebuilding an understanding of value creation and how it flows, mapping economics to what appears to be happening around me in the US and especially California, moving away from wanting to tax wealth and instead wanting to tax land (and being consistent about not wanting to tax income in either framework), and discovering the ironic, controversial of Monopoly — this entire journey has felt like a boardgame in its own right.

I hope you get past the “rules” and play for yourself. I played the 20 hour version of this quest so you can hopefully get the one-sitting experience.

(I love that Lars decided to play the fully-immersive-throw-your-life-into-the-game-version. That’s the true aspirational model of financial freedom — not “let me be so rich I can idle as an absentee landlord” but let me sustain a life doing the thing I want to be doing anyway.)

Stay groovy!

This past weekend, I cloaked myself in the robe of imposter syndrome and gave a talk to a small group of sophisticated investors. I don’t consider myself a great investor, my core portfolio is a simple asset allocation model in the vein of a permanent portfolio. The point of it is to preserve wealth so I have the slack to take shots using my human capital which I have more faith in than the meanderings of a drunk market.

That wasn’t going to be interesting to a group like this (although it’s a topic worth plenty of discussion for the average saver). Instead, I decided to talk about the beauty of options. It fails the test of giving a directly actionable investment idea, but if it helps extend an investor’s mental toolbox it would at least be worthwhile. Plus, I’m a hedgehog. Options are probably the only thing I’m justified to pontificate on. A pathetic, dull boy in 99% of contexts, but hopefully value-added here.

I started with the practical before wandering into the aesthetic.

A Practical Option Consideration

• 1. The directional use of options is trivial because most of the work is upstream of the option expression. If you have a divergent view of an asset’s distribution from what the volatility surface implies, trade expressions are often obvious. Any decent option broker or junior level option trader could probably help.
  2. So-called “vol trading” is irrelevant to 99% of the investing world  — it’s a low-margin business relying on the law of large numbers while also being capacity-constrained. In the bigger picture, it’s chess-boxing — nerds fighting. If you want to be really rich, find a way to get paid on beta.
  3. If directional trading is the most common use of options, then covered calls and hedging are the next most common. We can use a “replication mindset” to understand that even when you sell covered calls (or hedge) you are, regardless of how promoters sell the idea, engaging in a volatility trade.Consider my logic:
     • The alternative to selling a 20d call monthly: you can sell 20% of your position instead.
       1. Call selling: You get called away on your position about 1 in 5 months
       2. Selling the stock: you are out of your position in 5 months
     • The false accounting that the call seller uses to rationalize: “I get called away on my position less than 20% of the time so actually selling the calls is better”
     • Reality: You are failing to account for the times when the stock dives where you don’t get assigned on your short calls, but you would have been better off to have sold 20% of your position.

The spread between the false accounting and reality is a function of the volatility that was realized vs the IV you sold ¹

When you sell covered calls, whether it was a better choice than just selling the equivalent fraction of your position depends on what vol is realized vs what vol you sold.

If you sell calls too cheap you are better off just selling a fraction of your position and that’s why you shouldn’t sell calls indiscriminately for “income”. You need to consider whether the price is right.

Stop thinking of options through the lens of directional trading — you are still just trading volatility.

The Beauty of Options

I don’t actively encourage investors to trade options. In “Do You Even Trade Bro?” I offer a framework for deciding if you should bother. That said, learning about options and portfolio theory is worthwhile in both an appreciative sense — options are a “bicycle for the mind” and because it’s a useful lens for decision-making. Decisions are options.

The beauty of options theory and arbitrage pricing, in general, is in its replication mindset. Pricing derivatives is an exercise in finding and valuing a portfolio that would mimic the derivative’s payoff. If we combine the derivative with its replication, we have constructed a risk-free portfolio. The Black-Scholes formula prices an option by showing (under faulty but useful assumptions) that its cost should be equal to a trading strategy that rebalances a mix of cash and underlying shares until expiration. The rebalance between cash and shares depends on the probability of the underlying going through the strike price and by how much. That probability depends on the volatility of the asset and its distance from the strike, all normalized by time.

By studying the concept of replication (ie arbitrage pricing theory) you gain a new mental tool for approaching decisions.

Examples

1. In How Much Extra Return Should You Demand For Illiquidity?, I provide an options-based approach to thinking about how much extra yield you might require to hold a bond (like an EE bond or annuity-type investment) that you cannot sell. The key is to price the illiquid asset like the liquid version of the investment (ie Treasury bond) as the illiquid plus the option to rebalance. The higher the volatility, the more the rebalance option is worth. This confirms your intuition — the more volatile the world becomes, the more we should value liquidity.

If there is a large discount to buy an illiquid version of an investment, you are being offered a “deal” to effectively short volatility by abandoning the option to rebalance. When illiquid investments (ahem PE) argue that the illiquidity is an advantage for behavioral reasons (”protect yourself from selling during periods of stress”) they are standing in defiance of financial theory.

If you understand options conceptually, you can inoculate yourself from such motivated sales pitches. As an investor, if the stock market drops 25% and PE is not marking itself down, then you’d want to liquidate your PE investment at the nonsense mark and rebalance into the public markets. Of course, you can’t do that because the PE mark is not tradeable and you have forgone your option to rebalance. By not understanding options, you are the mark.

2. Understanding when a typical situation now has an option embedded

In Options on USO when oil went negative, I show how a popular oil ETF became an option. It began trading at a significant premium to its NAV — but thinking this was wrong was a fool’s trade. USO had turned into an option instead of a futures or “delta one” equivalent and the premium to NAV represented the volatility value of the option. (An easy way to see that USO had turned into an option is to realize you could have bought USO and shorted CL oil futures to structure a riskless trade — USO cannot go below zero but futures can!)

3. A final example comes from portfolio theory in general.

Portfolio theory shows us that if we have 2 assets that are only loosely or perhaps negatively correlated, a portfolio comprising a mix of both assets can have a better risk/reward than either of the components. In You Don’t See The Whole Picture, I give a simple math example to demonstrate this principle.

This principle has a deep implication — it means you don’t get paid for taking diversifiable risks. If I own a sunglasses company, I am the most “efficient bidder” for an umbrella company because I can diversify my weather risk. If markets are liquid, transparent, and the world transmits information cheaply then I should only expect to get paid for risks that are systematic, not idiosyncratic. Idiosyncratic risks are the types that can be diversified by being held by a party who owns the opposite type of risk (like the sunglasses/umbrella example).

A real-world example of this is the vol premium in oil puts when Pemex conducts its annual “Hacienda” hedge. Pemex, Mexico’s national oil company, hedges its forward production by buying puts and put spreads on oil futures. Typically this increases the value of the puts, enticing risk capital and arbitrageurs to sell the puts at a price that they believe exceeds their replication value.

However, I remember a year when Delta Airlines sold them the puts at a relatively fair price. This was a win for both Pemex and Delta. Delta is happy to sell the puts because they are “natural buyers” of oil via jet fuel (Delta also owns a refinery!)

This is a great example of markets doing their job. A risk that could be diversified was paired off between natural counterparties. However, from another perspective, this is bad news for investors who expected to earn the “sell expensive puts” risk premium. If a risk premium exists but it diversifies another party’s exposure, then that party can afford to pay more for it than the standard speculator. So the efficient frontier for speculators is just the set of investments that contain systemic risks that cannot be hedged.

The most obvious example is the equity risk premium in general — the corporate world is levered to financial growth. Corporations are owned by people in the population. Once all risks are netted, there is no stakeholder remaining who benefits from economic collapse. Therefore the only carrot to entice someone to invest in corporations, effectively doubling down on their reliance on economic growth, is a yield in excess of the risk-free rate. That’s an undiversifiable risk premium.

I’ve given more examples in *Why You Don’t Get Paid For Diversifiable Risks, but like any model or theory it’s not water-tight. It’s useful. This one is a reminder to consider if the risk you are being asked to underwrite should command a premium. If it was hedgeable by someone else more cheaply, why did it show up on your doorstep labeled “excess return”?

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Option trader and founder of Convexitas Devin Anderson drops some terrific insights in his interview with Bill Brewster on the Business Brew Podcast. I found them deeply resonant.

Episode link

I added my comments to the following excerpts which were taken from minutes 20-30 in the episode.

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“Risk Over Rules”

Risk vs rules-based approach

Risk-based limits are set for every mandate that we monitor throughout the day, every day. For each mandate, we agree on a size and determine the risk limits for the product. We manage within these risk bands for the handful of different products we have. This approach is different from a rules-based approach, which would dictate specific actions based on market conditions or other factors. Instead, we exercise discretion within the risk-based framework.

Example:

• The market exposure cannot be greater than the notional amount you have hired us for, and it must be negative.
• We cannot take a leveraged short.
• There are minimum amounts of convexity that we must maintain at all times
• [Our size is constrained by] shock scenarios.

There is a set of rules that determines the band of market exposure and the minimum amount of shock and spot convexity we must have, but it is up to us to decide how to implement those rules. We determine which part of the surface looks the most interesting, what the relative value is, and how much of it we should have on at any one point in time. This is a completely different way of thinking than simply investing a set amount and waiting to see what happens in the future.

“All good option trading has to start from biases in the market”

To draw a parallel to value investing. If you don’t believe that you have an edge in some stock, and you don’t believe that there’s a discount, then why should you own this thing? We can apply that same general framework to options trading, thinking about it as one level up. So there’s still the stock or the market or whatever the underlying equity is, that can have value in it. But then the options themselves have their own market, microstructure, flows, and biases. It’s not enough to say, “Well, I have a view on a stock, therefore, I’m going to trade some options.” If you’re going to trade some options, you have to say, “I have a view on the stock. And there’s this interesting thing in the options that makes trading the options worthwhile relative to just trading the stock.”

So in everything that we do, it starts from some biases in the option market. Those biases in the options market take the shape of flows and imbalances that result from forced trading, yield-seeking, or bank hedging. There are actually a bunch of sources of these.

[Kris: this is what Benn Eifert means when he says “disturbances in the force”. If there were no flows all the point spreads would be fairly priced. No “willing losers”, no opportunity.]

In our case, we buy short-dated options that we believe are inexpensive because there’s an avalanche of people selling them, ranging from private banks to other managers that look like us to even big institutions. There’s a depression in a certain part of the short-dated volatility surface, particularly S&P, that we think offers very good value. That’s solely because there are yield-generating programs out there that are pushing the prices down. Then we can go out on the long end of the curve and find really good values there in certain conditions when the market sells off because of the particular dynamics of the way structured products have to be re-hedged. So we look for certain flows after a market sell-off that tells us that that’s happening and we go out and trade those options. But the point is, a good options trading program needs to start from value in the options themselves, not a statement about the underlying. Ultimately, you have to be able to make a statement about the options and a statement about the underlying together.

“Beware of hockey players”

Inevitably you come across a private bank “options expert”, right? And he’s like, “I have my strategy and it works on all underlyings because I’m going to come in and trade my call or whatever it is, right?” But really, what he’s saying is:

“I’m trading options for their payout at expiry, without a lot of regard to whether there is any relative value in the options themselves.”

Just because you can buy a put and reshape the terminal payout of the terminal distribution out that options expiry doesn’t mean that that option is underpriced. It could be overpriced, and in fact, they often are. If I buy hurricane insurance after the rates have already gone up, like Yeah, I guess I’ve mitigated my downside, but what did I pay to buy the insurance?

[Kris: see It’s Not The Merit It’s The Price]

As a general rule, whenever you hear someone giving you a pitch about derivatives that are based on its terminal payoff, and they’re drawing hockey sticks for you, your radar needs to go up.

So we have a joke: “beware of hockey players.”

[Kris: think buffered ETFs or structured products]

On breakeven arguments

The only place where I have consistently seen breakeven arguments work is in biotech or pharma, where there are very specific events. If you have knowledge about the likely outcome of an event, you can look at the breakevens and determine whether it’s a good value. I have seen this strategy work in those industries.

[Kris: I’ve seen this in nat gas as well — what’s the common link? These are all special sits types of scenarios where the distributions vary greatly from lognormal or bell-curve shapes, often having 2 more modal outcomes.]

However, during my time on an institutional dealing desk for over a decade, I only met two people who could consistently trade options for direction without paying attention to biases and make money. Even then, I’m not convinced they were making that much money trading the options.

[Kris: See my discussion of path vs destination]

Options or re-size the position?

And then you need to ask the question: why these options? What is the mispricing or value in the derivative itself? if someone comes to you and is like, well, I you know, you should get long whatever sector in the option space they need to have a really good reason for why those sector options are mispriced.

What is special about the option pricing itself that makes doing this an option better than just re-sizing the position?

Kris: this is an absolute money question!

It relates back to how options are priced with specificity:

You are paying for specificity via options because they are priced with a particular vol to a specified expiry. The offsetting benefit is you are highly levered to being right.

From If You Make Money Every Day, You’re Not Maximizing:

The beauty of options is how they allow you to make extremely narrow bets about timing, the size of possible moves, and the shape of a distribution. A stock price is a blunt summary of a proposition, collapsing the expected value of changing distributions into a single number. A boring utility stock might trade for $100. Now imagine a biotech stock that is 90% to be worth 0 and 10% to be worth $1000. Both of these stocks will trade for $100, but the option prices will be vastly different.If you have a differentiated opinion about a catalyst, the most efficient way to express it will be through options. They have the most urgent function to a reaction. If you think a $100 stock can move $10, but the straddle implies $5 you can make 100% on your money in a short window of time. Annualize that! Go a step further. Suppose you have an even finer view — you can handicap the direction. Now you can score a 5 or 10 bagger allocating the same capital to call options only. Conversely, if you do not have a specific view, then options can be an expensive, low-resolution solution. You pay for specificity just like parlay bets. The timing and distance of a stock’s move must collaborate to pay you off.

Since you pay for specificity, you need a well-formed understanding of your edge. If you’re going to trade options directionally I would want to see the specificity in your fundamental analysis that suggests these particular options are the right options to buy or sell.

It’s so easy to lose on timing or changes in vol even if you get the direction right. See:

• How Options Confuse Directional Traders
• Structuring Directional Option Trades