Friends,
This week I published the longest post I’ve ever written. It’s long because it was liberal with stories. This is the long-winded story I used to introduce the concept of hedging.
If You Make Money Every Day, You’re Not Maximizing
This is an expression I heard early in my trading days. In this post, we will use arithmetic to show what it means in a trading context, specifically the concept of hedging.
I didn’t come to fully appreciate its meaning until about 5 years into my career. Let’s start with a story. It’s not critical to the technical discussion, so if you are a robot feel free to beep boop ahead.
The Belly Of The Trading Beast
Way back in 2004, I spent time on the NYSE as a specialist in about 20 ETFs. A mix of iShares and a relatively new name called FEZ, the Eurostoxx 50 ETF. I remember the spreadsheet and pricing model to estimate a real-time NAV for that thing, especially once Europe was closed, was a beast. I also happened to have an amazing trading assistant that understood the pricing and trading strategy for all the ETFs assigned to our post. By then, I had spent nearly 18 months on the NYSE and wanted to get back into options where I started.
I took a chance.
I let my manager who ran the NYSE floor for SIG know that I thought my assistant should be promoted to trader. Since I was the only ETF post on the NYSE for SIG, I was sort of risking my job. But my assistant was great and hadn’t come up through the formal “get-hired-out-of-college-spend-3-months-in-Bala” bootcamp track. SIG was a bit of a caste system that way. It was possible to crossover from external hire to the hallowed trader track, but it was hard. My assistant deserved a chance and I could at least advocate for the promotion.
This would leave me in purgatory. But only briefly. Managers talk. Another manager heard I was looking for a fresh opportunity from my current manager. He asked me if I want to co-start a new initiative. We were going to the NYMEX to trade futures options. SIG had tried and failed to break into those markets twice previously but could not gain traction. The expectations were low. “Go over there, try not to lose too much money, and see what we can learn. We’ll still pay you what you would have expected on the NYSE”.
This was a lay-up. A low-risk opportunity to start a business and learn a new market. And get back to options trading. We grabbed a couple clerks, took our membership exams, and took inventory of our new surroundings.
This was a different world. Unlike the AMEX, which was a specialist system, the NYMEX was open outcry. Traders here were more aggressive and dare I say a bit more blue-collar (appearances were a bit deceiving to my 26-year-old eyes, there was a wide range of diversity hiding behind those badges and trading smocks. Trading floors are a microcosm of society. So many backstories. Soft-spoken geniuses were shoulder-to-shoulder with MMA fighters, ex-pro athletes, literal gangsters or gunrunners, kids with rich daddies, kids without daddies). We could see how breaking in was going to be a challenge. These markets were still not electronic. Half the pit was still using paper trading sheets. You’d hedge deltas by hand-signaling buys and sells to the giant futures ring where the “point” clerk taking your order was also taking orders from the competitors standing next to you. He’s been having beers with these other guys for years. Gee, I wonder where my order is gonna stand in the queue?
I could see this was going to be about a lot more than option math. This place was 10 years behind the AMEX’s equity option pits. But our timing was fortuitous. The commodity “super-cycle” was still just beginning. Within months, the futures would migrate to Globex leveling the field. Volumes were growing and we adopted a solid option software from a former market-maker in its early years (it was so early I remember helping them correct their founder correct the weighted gamma calculation when I noticed my p/l attribution didn’t line up to my alleged Greeks).
We split the duties. I would build the oil options business and my co-founder who was more senior would tackle natural gas options (the reason I ever got into natural gas was because my non-compete precluded me from trading oil after I left SIG). Futures options have significant differences from equity options. For starters, every month has its own underlyers, breaking many arbitrage relationships in calendar spreads you learn in basic training. The first few months of trading oil options, I took small risks, allowing myself time to translate familiar concepts to this new universe. After 6 months, my business had roughly broken even and my partner was doing well in gas options. More importantly, we were breaking into the markets and getting recognition on trades.
[More on recognition: if a broker offers 500 contracts, and 50 people yell “buy em”, the broker divvies up the contracts as they see fit. Perhaps his bestie gets 100 and the remaining 400 get filled according to some mix of favoritism and fairness. If the “new guy” was fast and loud in a difficult-to-ignore way, there is a measure of group-enforced justice that ensures they will get allocations. As you make friends and build trust by not flaking on trades and take your share of losers, you find honorable mates with clout who advocate for you. Slowly your status builds, recognition improves, and the system mostly self-regulates.]
More comfortable with my new surroundings, I started snooping around. Adjacent to the oil options pit was a quirky little ring for product options — heating oil and gasoline. There was an extremely colorful cast of characters in this quieter corner of the floor. I looked up the volumes for these products and saw they were tiny compared to the oil options but they were correlated (gasoline and heating oil or diesel are of course refined from crude oil. The demand for oil is mostly derivative of the demand for its refined products. Heating oil was also a proxy for jet fuel and bunker oil even though those markets also specifically exist in the OTC markets). If I learned anything from clerking in the BTK index options pit on the Amex, it’s that sleepy pits keep a low profile for a reason.
I decided it was worth a closer look. We brought a younger options trader from the AMEX to take my spot in crude oil options (this person ended up becoming a brother and business partner for my whole career. I repeatedly say people are everything. He’s one of the reasons why). As I helped him get up to speed on the NYMEX, I myself was getting schooled in the product options. This was an opaque market, with strange vol surface behavior, flows, and seasonality. The traders were cagey and clever. When brokers who normally didn’t have business in the product options would catch the occasional gasoline order and have to approach this pit, you could see the look in their eyes. “Please take it easy on me”.
My instincts turned out correct. There was edge in this pit. It was a bit of a Rubik’s cube, complicated by the capital structure of the players. There were several tiny “locals” and a couple of whales who to my utter shock were trading their own money. One of the guys, a cult legend from the floor, would not shy away from 7 figure theta bills. Standing next to these guys every day, absorbing the lessons in their banter, and eventually becoming their friends (one of them was my first backer when I left SIG) was a humbling education that complemented my training and experience, illuminating some ways of thought that would have been harder to access in the monoculture I was in (this is no shade on SIG in any way, they are THE model for how to turn people into traders, but markets offer many lessons and nobody has a monopoly on how to think).
As my understanding and confidence grew, I started to trade bigger. Within 18 months, I was running the second-largest book in the pit, a distant second to the legend, but my quotes carried significant weight in that corner of the business. The oil market was now rocking, with WTI on its way to $100/barrel for the first time, and I was seeing significant dislocations in the vol markets between oil and products. This is where this long-winded story re-connects with the theme of this post.
How much should I hedge? We were stacking significant edge and I wanted to add as much as I could to the position. I noticed that the less capitalized players in the pit were happy to scalp their healthy profits and go home relatively flat. I was more brash back then and felt they were too short-sighted. They’d buy something I thought was worth $1.00 for $.50 and be happy to sell it out for $.70. In my language, that’s making 50 cents on a trade, to lose 30 cents on your next trade. The fact that you locked in 20 cents is irrelevant.
You need to be a pig when there’s edge because trading returns are not uniform. You can spend months breaking even, but when the sun shines you must make as much hay as possible. You don’t sleep. There’s plenty of time for that when things slow down and they inevitably will. New competitors will show up soon enough and the current time will be referred to as “the good ole’ days”. Sure enough, that is the nature of trading. The trades people do today are done for 1/20th the edge we used we used to get. That’s not fully explained by falling costs. That’s progress of human knowledge and returns to scale.
I started actively trading against the pit to take them out of their risk. I was willing to sacrifice edge per trade, to take on more size (I was also playing a different game than the big guy who was more focused on the fundamentals of the gasoline market, so our strategies were not running into one another. In fact, we were able to learn from each other). The other guys in the pit were not meek or dumb. As I said earlier, they were bright. Many simply had different risk tolerances because of how they self-funded and self-insured. My worst case was losing my job, and that wasn’t even on the table. I was transparent and communicative about the trades I was doing. I asked for a quant to double-check what I was seeing.
This period was a visceral experience of what we learned about edge and risk management. It was the first time my emotions were interrupted. I wanted assurance that the way I was thinking about risk and hedging was correct so I could have the fortitude to do what I intellectually thought was the right play.
Money Angle
The rest of the post gets into a proper discussion of hedging:
What Is Hedging?
Investopedia defines a hedge:
A hedge is an investment that is made with the intention of reducing the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting or opposite position in a related security.
The first time I heard about “hedging”, I was seriously confused. Like if you wanted to reduce the risk of your position, why did you have it in the first place.? Couldn’t you just reduce the risk by owning less of whatever was in your portfolio? The answer lies in relativity. Whenever you take a position in a security you are placing a bet. Actually, you’re making an ensemble of bets. If you buy a giant corporation like XOM, you are also making oblique bets on GDP, the price of oil, interest rates, management skill, politics, transportation, the list goes on. Hedging allows you to fine-tune your bets by offsetting some of the exposures you don’t have a view on. If your view was strictly on the price of oil you could trade futures or USO instead. If your view had nothing to do with the price of oil, but something highly idiosyncratic about XOM, you could even short oil against the stock position.
Options are popular instruments for implementing hedges. But even when used to speculate, this is an instance of hedging bundled with a wager. 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. Imagine a typical utility stock that trades 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.1
If you have a differentiated opinion about a catalyst, the most efficient way to express it will be through the 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! If you have an even finer view — you can handicap the direction, 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 a parlay. The timing and distance of a stock’s move must collaborate to pay you off.
So options, whether used explicitly for hedging or for speculating actually conform to a more over-arching definition of hedging — hedges are trades that isolate the investor’s risk.
The Hedging Paradox
If your trades have specific views or reasons, hedging is a good idea. Just like home insurance is a good idea. Whether you are conscious of it or not, owning a home is a bundle of bets. Your home’s value depends on interest rates, the local job market, state policy. But also on some pretty specific events. Your house value depends on “not having a flood”. Insurance is a specific hedge for a specific risk. In The Laws Of Trading, author and trader Agustin Lebron states rule #3:
Take the risks you are paid to take. Hedge the others.
He’s reminding you to isolate your bets so they map as closely as possible to your original reason for wanting the exposure.
You should be feeling tense right about now. “Dude, I’m not a robot with a Terminator HUD displaying every risk in my life and how hedged it is?”.
Relax. Even if you were, you couldn’t do anything about it. Even if you had the computational wherewithal to identify every unintended risk, it would be too expensive to mitigate2. Who’s going to underwrite the sun not coming up tomorrow? [Actually, come to think of it, I will. If you want to buy galactic continuity insurance ping me and I’ll send you a BTC address].
We find ourselves torn:
- We want to hedge the risks we are not paid to take.
- Hedging is a cost
What do we do?
Before getting into this I will mention something a certain, beloved group of wonky readers are thinking: “Kris, just because insurance/hedging on its own is worth less than it’s actuarial value, the diversification can still be accretive at the portfolio level especially if we focus on geometric not arithmetic returns…rebalancing…convexi-…”[trails off as the sound of the podcast in the background drowns out the thought]. Guys (it’s definitely guys), I know. I’m talking net of all that.
As the droplets of caveat settle the room like nerd Febreze, let’s see if we can give this conundrum a shape.
Reconciling The Paradox
This is a cornerstone of trading…
Edge scales linearly, risk scales slower
Continue reading:
✍️If You Make Money Every Day, You’re Not Maximizing(28 min read)
From My Actual Life
A month ago I started tutoring elementary school students in math. These kids are in vulnerable communities that were hit extra hard by the impact of remote learning. They are one or more grades behind standards.
One-on-one instruction is effective but a luxury. The non-profit always needs more volunteers. Without volunteers, this cannot happen.
The organization offers training before you start as well as all the supplies you need. There are opportunities to teach in-person for reading and remote for math.
If you live in CA you can help!
You only need to get your fingerprints done for a background check and be willing to commit 30 minutes a week. You can do more if you like. I do 2 sessions a week with a second-grader and a third-grader. You don’t need to be “good” at math. If you can count backward from 10 to 5, you already know things that these kids need help with. Seriously.
Ping me if you are interested. This will give you time to get your background check and training (training is just a few hours).
The next sessions will be summer and then the return to school in the fall.
