Moontower #321

In this issue:

• Experts make decisions faster than they can process. How?
• How I teach middle-schoolers to build stock portfolios
• The zoo of option structures masks the simplicity

Friends,

I didn’t know that author David Epstein (Range, The Sports Gene, Inside The Box) had a YouTube channel until I watched this awesome video.

The hook is timely and well-constructed. It starts by litanying just how ridiculous Messi plus a puzzle…Messi walks for over 90% of the game. What is he doing?

David breaks down the cog-sci idea of “chunking” and how it relates to domain expertise. He offers 3 concepts to keep in mind as you build skills in your chosen lane.

It’s a well-done 15-min video. I was watching it at breakfast with my 13-year-old and 3 10-year-olds (post sleepover), and they were glued to the screen. It comes to life with examples not just from soccer (the Ronaldo thing is nuts), but baseball, boxing, chess, and football. My favorite demo was the one David made to animate what it’s like to be a quarterback that Drew Brees once gave in a talk.

Money Angle

If you construct a portfolio from 2 stocks and one is $100 and the other is $10, buying a share of each means the first will dominate your portfolio’s risk, assuming they have the same volatility.

If you have $100,000 to invest, you can balance the risk by equal-weighting the holdings: $50k into each stock. You buy 500 shares of A and 5,000 shares of B.

But what if they aren’t the same volatility?

Equal-weighting means the most volatile stocks determine performance. If your $100,000 is split equally between the 2 stocks and A moves 10% per day while B moves 1% per day, you aren’t diversified. Stock A will mostly determine your returns.

We can achieve more balance via equal-risk-weighting, which adjusts how many dollars go into each stock based on its volatility.

Weight each stock by 1/vol:

• Stock A gets 1/10
• Stock B gets 1/1.

Divide by the total (1/10 + 1 = 1.1) and you get about 9% in A and 91% in B. Stock A is 10x as risky, so it gets about 1/10th the dollars.

On $100,000 that’s roughly $9k of A and $91k of B, corresponding to

• 91 shares of A
• 9,100 shares of B

Compared to the equal-dollar portfolio, the equal-risk portfolio requires you’d sell about 409 shares of A and buy about 4,100 shares of B, moving roughly 41% of your total portfolio value from the jumpy stock to the calm one.

No masochism for the kids but in case you’re interested…

Equal risk weighting is the starting point for so-called risk parity weighting. The difference is that instead of only considering the volatility a holding adds to the portfolio, the correlation is considered. A stock highly correlated with the rest of your portfolio contributes a lot of risk, while an anti-correlated one does a better job diversifying and reducing total portfolio risk. The effect can be so strong that even a highly volatile but anti-correlated stock can reduce total risk.

Computing a correlation-aware risk contribution requires a full covariance matrix and an optimizer — i.e., a guess-and-test calculator — to find the portfolio weights, since there’s no closed-form solution. If the kids can grok equal vol-weighting I feel like I’ve done my job, and they can discover risk parity on their own if they’re so inclined.)

Your own Portfolio HQ Spreadsheet

This workbook is designed to organize and monitor your first portfolio.

⏬ Download

The sheet is view-only. Select “duplicate” from the file menu to get your own copy.

In this video, I show you how to use the sheet and talk about the Investment “lab” we did this week.

Money Angle For Masochists

To piggyback off David Epstein’s explanation of chunking, I’ve discussed the technique several times in my writing in the context of options. I use the chess player’s word for it (although I’m not a chess player): dissection.

These articles give concrete examples:

• Path, VIX, & Hit Rates vs Expectancy
• the right bogey: trades that seem compelling but aren’t and vice versa

The second one links to a video where you can follow along on an example.

At first, you consciously look for groups or patterns that compress a theme, but with practice this becomes automatic. You can’t help but see the pattern.

Like the sports examples, an experienced trader will be able to pull the trigger faster than slavish processing would allow. The shortcuts become part of their wiring. You could see this in an open outcry trading pit or even amongst the best mock trading students back in the old floor days. That ability to say “sold” or “buy’em” faster than a large group of competitive traders because you saw the arb line up is happening at a subconcious pattern level. You make the trade and working out the particulars of the “why” while the instructor is still in the act of halting the the class to ask why you made the trade. I don’t know how it works but my pop science guess is that your synapses which have been strenghtened along specific pathways are a step ahead of your explicit reasoning.

Dissection is a deliberate form of “chunking”. But if we zoom out a ring from the specifics of option structures to the parameters they express, there are only 3 we generally care about: volatility (or variance), skew, kurtosis. In stats terms, these map to the 2nd, 3rd, and 4th statistical moments of the distribution.

There’s a vanna-vega-volga model sometimes referred to as “the cost of gammas” framework which actually formalizes this idea by mapping the parameters to their costs.

Volatility is represented by the cost of the straddle.

Skew is represented by the cost of a risk reversal.

Kurtosis is represented by the cost of a strangle.

These map to pertinent Greeks as well:

straddle → vega

RR → vanna

strangle → volga

You pay IV premiums for all of these convexities. Vol risk premia for the straddle, you pay skew premiums for the ability to be long spot-vol correlation in the direction for which IV tends to rise as the market moves (so in SPY you pay a premium for the puts but in oil today you pay a premium for the calls), and finally, for volga, or “vol gamma” you pay an IV premium for wingy options.

To a beginner, the zoo of option structures is overwhelming. Seriously look at this page, the screenshot is only part of what I could capture:

It doesn’t even cover them all. There’s still jelly rolls, Christmas trees, rev/cons, diagonals, strips, “stupids”. I’m not kidding on that last one (it’s buying or selling a package of options in the same maturity but different strikes, so buying both the 700 and 650 puts as opposed to spreading them).

But if you understand that there are only 3 parameters we care about, then all of this collapses into a few themes. There’s a million different types of cocktails, but according to the mixologists at Death & Co there’s just key elements to the drink:

1. alcohol (base)
2. sugar (sweetener)
3. acid (brightener)

If you prefer the cooking analogy, it’s salt, fat, acid, heat.

All recipes, whether in options, cuisine, music (there are thousands of chords but you can collapse to major/minor modified by dominant, sus, and add9) can be reduced to a few themes.

How does this help?

I’ll give you an example from our Discord this week.

Someone asked:

Anyone got any ideas for screening for good call spreads or put spreads to buy systematically in a potentially semi-automated way using moontower. A lot of the guidance I’ve read is ‘if you have a directional view’… well umm, I’m a ding dong with no directional ideas want something algorithmic.

I’m also a ding-dong, I just happen to understand that the price of option structures derives from the cost of our 3 friends: volatility, skew, and kurtosis.

This was my response:

Our Trade Ideas algo scores names based on how they stack up to various preset trade themes (ie “buy vol”, “sell vol”, “long calendar”) according to their parameters and what signatures we look for. You simply add the column for 25d call skew which tells you the percentile, and using the logic from my answer, find names where the parameters present attractive spreads.

You had to understand that the price of the option structures map to these 3 themes in the first place and suddenly the zoo of possible option trades is massively reduced in dimensionality. It’s the progression from option bartender at your college party to option mixologist where you understand that all drinks are just a few flavors.

And just to address the Automations thing, we have a new feature in our tool. An example of one of mine where the agent emails me on a schedule when a name with a strong “Buy Vol” score’s strike vols are down and vice versa:

From My Actual Life

The CA side of our family has a summer tradition called Cousins Camp that started 6 years ago.

This is the first time it’s not a full week as the scheduling gods are not cooperating. We stuffed into this weekend from Friday morning through Sunday.

It’s 8 kids ranging from age 10 to 16 (the eldest drives now!)

 

The “make a magazine” idea stems from our household love for Oyla. I made a short thread about it here:

 

Some people would call these the dog days of summer, but they are my favorite days. Even though you sometimes want to break it up with A/C…we’re doing a matinee with the kids to see Odyssey in 70mm IMAX this week. We don’t go to the movies often so this has the right summer throwback energy.

 

Stay groovy

☮️

Moontower Weekly Recap

• the iron butterfly
• uncovering the laws of nature