In this issue:
- AI leaves the hardest problems to humans
- The triggering implication of arbitrage theory
- options rapid fire
- Nine Inch Noize
Friends,
A thought sparked by the digital id known as X…
AI anxiety takes many forms. Doomerism, FOMO, a sense that the value you may have associated with your efforts is now solved by power cycles, or simply being overwhelmed by its usefulness, making it difficult to triage.
AI forces us to price even more tradeoffs, mostly in the form of explore/exploit problems. In other words, lots of tasks became easier, leaving diabolically hard ones to focus on, namely, “what should I be doing?”
My answer is mostly to be doing more of what I’m doing faster. I admit this is incremental and I’m a little ashamed of that, but I’ve already told you I feel like I’m the American in 1920 who saw a car and thought, “I could use that to go buy food for my horse”.
If you do your work faster, you can do more work. I heard this is called Jevon’s Paradox, which is some economic idea that caught fire like “Baumol’s disease” or “network effects” or “EBITDA”.
Gemini defines Jevon’s paradox:
The Jevons paradox is an economic observation that increased efficiency in using a resource tends to increase, rather than decrease, its total consumption. Proposed by William Stanley Jevons in 1865 regarding coal use, it occurs because higher efficiency lowers the cost of using the resource, driving higher demand that outweighs the initial savings.
Well, ain’t that the truth. Don’t mind me, I’m just over here paying off “intention debts” when I should be…[trails off]. If you feel the same, I see you.
Money Angle
As I expected, the post how to get arbed with perfect info would trip people up. I didn’t expect confusion because I thought Professor Doug Costa, whose explanation is featured in that post, was itself confusing. But because the concept of replication is hard and feels like it violates the good. It’s triggering. It means you can know the truth and still get arbed. Again, this is why I call it the pons asinorum of finance.
A reader brought it up in our Discord so I’m going to share the discussion here as he felt like our back and forth helped.
Before getting to the conversation, let’s refresh the problem Doug set up:
A company issues contracts based on a provably fair coin. The contract pays $150 on heads, $75 on tails. It trades at $100. Interest rate is 0%.
You calculate the true expected value of the 110 call using the true probability of 50%.
It’s worth $20 because it has a 50% chance of being $40 in-the-money.
You pay $20 for it (but even if you paid a bit less for an unambiguously positive EV trade, this analysis will hold. I just want to stay with Professor’s example)
The dealer sells it to you, hedges with 8/15 of the underlying contract, and locks in $6.67 profit in both states. Pure arb.
You had perfect information about the true probability and you still got arbed. The dealer made money in all scenarios, trading the call at fair value with you.
Doug is showing how the real-world probability doesn’t matter to the derivatives trader if they can also trade the underlying. In this case, the underlying is mispriced, but the dealer doesn’t know that. All the dealer cares about is whether the relationship between the derivative price and the underlying price is mispriced. In this contrived example, the mispricing was more profitable than knowing the true probabilities.
And to add something Doug doesn’t mention…if the investor knew the stock was underpriced and bought that instead, they’d have a positive EV trade (the fair price of the stock is $112.50) but they are still worse off than the dealer who knows the relative value of the 2 securities is wrong and gets to make a profit in all scenarios.
This is a good place to insert the chat.
Reader: I see, so the main point is we can converge a spread by trading two things instead of betting on one.
Kris: In a world with no derivatives, you’re left with having to be good at guessing real-world probabilities, but derivatives are their own source of possible edge that doesn’t inherit from knowledge of the future but from relative mispricings between the derivative and the underlying.
It’s obvious that being able to handicap probabilities would be a source of edge, but it’s quite subtle that once you introduce derivatives and the idea of replication, there becomes a source of profit that doesn’t rely on such an ability.
Reader: Right, so it’s instructive in giving one more spread to look at. If you used a put in your example, then the dealer would lose because they’d be too short. Then a dealer that actually has no information and sells both sides ends up $0. This example is picking the (long) side where it wins.
Kris: Yeah, the underlying in this example is too cheap RELATIVE to the call option.
If the call option was $13.33, then from the vantage point of real-world probability, both the underlying and call are too cheap, but they are priced correctly with respect to each other.
Which makes the point — if a derivative and underlying are correctly priced to each other, then the real-world probability is not important to the dealer. The dealer only cares about the relative values.
You can just compute the Sharpe of buying one vs the other I suppose to see which is better (that’s one lens). The call is more underpriced in % terms, 3.33 when it’s worth 20. But it’s more volatile as it will lose all of its value when it loses.
I’d just stick them both in a Kelly calculator in Claude or something and whichever one it says bet more on is the better one lol.
There are some important implications here. And brain damage — investor brain and derivatives brain collision.
The goal is that derivativesbrainskill.md becomes something one calls as needed, like Neo downloading kung fu. But you don’t wanna get carried away with it and shoot it at everything in life. It’s this weird artificial thing that works in a replication context, but it’s also not artificial in that its violation presents hard cash arbitrage!
That’s the end of the chat, but let me add one more thing to make you feel better if it’s still foggy.
I’ve seen this subtlety trip up seasoned options traders where they take B-S pricing to mean that the forward for a stock is stock grown at the risk-free rate (RFR), but this is ONLY true in a world where you can trade the underlying AND the options. Outside the context of replication, you cannot make that assumption.
Struggling with this idea is entirely forgivable. I mean, the realization that you could use RFR as the discount rate was a revolutionary breakthrough. Bachelier figured out option pricing in the early 1900s, but he and his contemporaries were stumped by what rate to discount the payoffs.
Later academics wondered if you should use something like the required return from CAPM or something, but it was the whole idea that if you trade a derivative vs the underlying against one another, then you can have equivalent payoffs and therefore it’s riskless to go long one and short the other. If it’s riskless, then RFR is the appropriate discount rate.
Warren Buffett sees the necessity of agnostic dealers using the RFR to price options in arbitrage-free ways as an opportunity. He asserts that put options are overpriced because they use too low of a discount rate, but the dealers don’t care so long as they can trade the underlying, they can arb any other rate assumption. Again, so long as “they can trade the underlying.”
This single idea allows derivatives traders who know nothing about the fundamentals of securities to make money in a sea of people who do. It’s quite profound and not a small part behind why I think vol trading is easier than directional trading.
Money Angle for Masochists
Rapid-fire format today:
1) A reminder that trading vol is not trading a line on a chart
Selling vol when it’s high because it’s mean-reverting is not like selling a stock that is going to fall. Option performance depends not just on what happens to implied vol but on how much the stock moves. If it were as simple as selling an IV number before it went down, just sell equity options just before earnings come out. I’m 99.9% sure the implied vol is going to fall after the announcement.
Just remember:
If you are trading near-dated option just think “I’m not trading implied vol I’m trading straddles”. The further you go out in time, the more it’s like trading implied vol since those options are dominated by vega, not gamma and theta.
2) Avis stock
Ticker CAR has been squeezing higher as activist owners with locked up float collide with heavy short interest.
As you might guess, I’m getting messages about the positive delta puts post.
Refreshing a perma-disclaimer: I’m not an advisor. You are responsible for your own actions.
3) ICYMI
Thursday’s post was especially well-received perhaps because it’s highly relevant for option sellers. Just to bring it to your attention again:
A devilish question for option sellers: Which VRP is higher?
It is a fuller response to the quote-tweet from a month ago:
To be blunt, if it were as easy as “sell vol when IV is high” you’d need to believe that option traders, a cohort known for being stupid, never noticed the obvious.
And finally, a reminder of the Moontower Review of option-based ETFs ISSB and ISBG:
This Week In The Options Trench
From My Actual Life
My wife tells me the internet is calling the Nine Inch Noize set last weekend the best in Coachella history. Nine Inch Noize is a mash-up of Nine Inch Nails and German DJ Boyz Noize
These are subjective things, of course, but I’m not surprised by the sentiment. I’ve seen NIN 3x in the past 3 years and the last 2 were with Boyz Noize on the Peel It Back Tour. I’m tired of raving about them. I don’t listen NIN regularly (well, more so now), but the recordings don’t do the in-person experience justice. You can watch YT clips to get a sense of the lasers and effects which are impossibly creative. The Coachella show was different than the tour shows so that’s something to appreciate of its own.
The tour shows have sections where it’s just Trent, sections with Trent and the band without the drummer (who by the way the alien Josh Freese), the full band, and then the tracks with Boyz Noize which thump real hard.
On Friday they dropped the first Nine Inch Noize album. The Pitchfork review is worth a read if any of this is interesting to you. It gives a lot of context not just to the album but the Peel It Back Tour as well.
🔗Pitchfork Album Review of Nine Inch Noize
The song I’m currently obsessed is an old one from the With Teeth LP. He opens his shows with it solo on the piano, which has a different feel than the recorded version. The recorded version has that velcro static fuzz sound that I f’n love, but it’s not for everyone.
Recorded version:
Live:
And my favorite cover of it has a beautiful orchestration and recording:
Stay groovy
☮️
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