Moontower #112

Greetings from Tahoe!

My family is traveling for 2 months and this is our first stop. I will be online much less than usual if the past week is any indication. My total computer screen time was about an hour. Expect more blurbs, less long posts, and shorter Moontowers this summer.

Here’s a few things I’ve enjoyed recently that cultivate a mindset that counteracts the trader residue I narrowly described in How I Misapplied My Trader Mindset To Investing:

  • Liminal Warmth 

    I came across this blog via the Twitter account @liminal_warmth. I was deep into several posts that grabbed my attention. There are lots of essays so I reached out to ask for which posts LW recommends. And voila, this thread will get you started.

    LW lives their own divergent script so it’s not surprising that the writing is unique and provocative. In addition to living in a van in a desert and writing tons of fiction, LW is a solopreneur/freelancer with tons of hard and soft skills for hire.

    I’ll single out an excerpt I found resonant from The Weirdness of Becoming Attractive in Your 30s (Link):

    Weirdly enough developing more empathy and more compassion and listening more and being more respectful of other people started working its way into my feelings toward myself… and I started hating who I was a little less. And I realized for the first time that attraction is as much about how you make other people feel as how you look (and arguably much more important). This completed a puzzle piece in my communication style that had always been missing. And it was so weird because I suddenly had this massive wave of empathy for everyone around me and I wanted everyone to feel special and pretty and liked because I knew how much it hurt to not feel that way. So again, I spent more time being actively interested in other people and trying to make them feel good and got more feedback loop results where I got positive attention in response and I felt amazing that I was able to make other people feel good and happy too.

    There’s nothing more addicting than watching people believe in themselves. Just observe a kid that learned to ride a bike or swim. I have a saying that compliments are the cheapest source of capital. Not in a fake or hollow way. But when someone is just doing their thing and you notice it’s awesome, even if it’s not grandly remarkable, just tell them. It unlocks people in a way that everyone wins.

  • The Scarcity Struggle (essay)

    This post is an outstanding reference for battling a zero-sum mindset. It chronicles the author’s own journey but many of you will be able to relate. It’s much better than my own writing on the topic so I will just leave you to read it.

    It reminds me a hack we use around our house: “You can’t be negative when you are in state of gratitude”. You are the object of someone else’s envy for one reason or another. Everyone is dust eventually. No point in doing anyone else but you.

The Money Angle

If “high” was expensive and “low” was cheap then trading would be easy. I’ve discussed this tension in:

I was recently asked the following question:

Hey Kris, got a beginner question for you if you have some time. Why do people recommend selling ATM spreads instead of slight OTM? If there’s a smile, it seems to make sense to sell the higher IV wing.

Re-stated more generally, the question is:

Why would I ever buy a higher IV or “skewed” option to sell a lower IV option?

You can get into a long discussions about greeks, liquidity, jump probabilities, distributions and their moments, and spot-vol correlations. They will all lead you back to the idea that “high IV” doesn’t mean expensive IV. It’s not an encouraging answer if you are looking for simplicity.

But let me offer a constructive perspective to help you along.

It’s not hard to understand why skew exists in option markets:

  • supply/demand of risk (ie hedging and overwriting flows)
  • correlations increasing when risk premiums expand (here’s my thread on dispersion)
  • fundamentally, a stock is more levered when it’s equity value falls

In addition to those, I’m sure there are technical (ie lots of math) reasons involving jump models and higher statistical moments. I’m not smart enough for that. Many option traders probably aren’t. But one of the ways to survive/thrive is to take a more intuitive approach.

The logic flows as follows:

  1. Markets are pretty smart. It’s naive to think “high” equals expensive.
  2. Implied vols are a useful ruler for comparing vols but I can’t read too much into them as valuation tools since the underlying distributions are unknowable.
  3. Market prices contain extra intelligence or assumptions about a stock’s distribution but Black-Scholes assumes a singular distribution leading to differential implied vols. (Those differences are a fudge because we are standardizing the underlying distribution, even though we know the market is capable of handicapping a multitude of conditional distributions.)
  4. Focus on relative pricing to make your process less model-dependent. This lets the model errors “cancel out”.

Here’s an example of this relative thinking that I explained to the learner:

Suppose I found 20 reasonably correlated names that all have skews more expensive that at-the-money IV. If you sorted the skewed options as a percent of ATM vol there would be a top half and bottom half of expensiveness. But if you looked at just the cheapest one naively in isolation you would want to sell the skewed option. But zoomed out in a cross sectional view you would have wanted to buy it.

If you are only trading one name you are in the domain of my post Structuring Directional Option Trades. In this case your fundamental analysis is upstream of your option trade expression. So be careful about mixing up vol trading which requires a zoomed out lens and directional options trading which requires a deep  understanding of a single name’s distribution (see Real Talk On Options Trading).

A possible compromise between the approaches is to look at a time series of the skew relative to ATM to see if it’s low end or high end of normal. This will still deceive you in cases when all the skews in the market converge. For example when all skews in the market are “high”, if you look at your name in isolation you still won’t know if it’s relatively “high”. A proper cross-sectional method will benchmark to a liquid name or basket that can be considered “fair”.

So that’s 3 lenses. Cross sectional, fundamental, and time series. It would be nice if your trade idea looked good on a all 3 filters, but option traders usually have limited visibility into fundamentals so it’s too high a bar for pulling a trigger.

How can option traders make up for that incomplete picture? The same way poker players use betting patterns to narrow a hand.

Here’s a clue:

Last Call

On the drive up to Tahoe, Yinh had me listen to her latest obsession. The Smartless podcast. It’s hosted by Jason Bateman, Will Arnett, and Sean Hayes. The setup is fun. Each episode, one of the hosts surprises the other two with a guest from their Rolodex. All three episodes I listened to were great — Tina Fey, Julia Louis-Dreyfus, and Mitch Hurwitz (creator of Arrested Development). The podcast has amazing behind-the-scenes energy and you pick up many nuggets about how showbiz works. As you might expect, these hosts’ ability to riff on their feet is other level compared to most pods.

Listen at Smartless

I’ll leave you with one of Arnett’s throw-away comments:

“Life is all vibration. You get back what you put out there.”

Leave a Reply