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



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


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.

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