There’s No Such Thing as a Stock-Market Bubble | 4 min read
Last week, Jeff Yass, founder of Susquehanna, published an op-ed There’s No Such Thing as a Stock-Market Bubble in the WSJ. It’s the same talk he gave our office in the early 2000s.
In 1999, just as today, when share prices fall, it isn’t a delusion correcting. It’s uncertainty resolving.*
My resolution for why the resolution of uncertainty resolves downwards from my post Why Investing Feels Like Astrology:
“The intrinsic value increases as it makes profits, but its extrinsic value declines. The number of forked paths ahead of it evaporates faster than its fundamentals could ever make up for. It’s the same feeling you’d have if you bought a put option on a stock and lost money even if the stock fell. You overpaid for the extrinsic which receded more than the stock’s decline.”
A stock price is the market’s probability-weighted guess under uncertainty. It is perfectly sensible for stock prices to soar in the context of a paradigm shift in technology, and for the most likely outcome to be a negative return or even a zero. The stock’s price is concerned with the expected value, which is probability times outcome. A tiny probability of massive upside will rationally assign a hefty valuation to the stock, but both can be true at once: a sensible expected value and a most likely outcome of zero.
But as Jeff says in the article and I’ve covered repeatedly, the options market will tell you what possible scenarios are driving the valuation. A stock price is a grainy snapshot, but an option surface is a high-definition movie with all of its strikes and expiry dates.
One of the cleaner examples of this comes from commodities pricing. Natural gas prices are vulnerable to winter squeezes. The so-called “widowmaker,” the March-April futures spread, trades as a referendum on winter supply/demand balances. From What The Widowmaker Can Teach Us About Trade Prospecting And Fool’s Gold:
The truth is the gas market is very smart. The options are priced in such a way that the path is highly respected. The OTM calls are jacked, because if we see H gas trade $10, the straddle will go nuclear.
Why? Because it has to balance 2 opposing forces.
It’s not clear how high the price can go in a true squeeze or shortage
The MOST likely scenario is the price collapses back to $3 or $4.
Let me repeat how gnarly this is.
The price has an unbounded upside, but it will most likely end up in the $3-$4 range.
Try to think of a strategy to trade that.
Good luck.
Wanna trade verticals? You will find they all point right back to the $3 to $4 range.
Upside butterflies, which are the spread of call spreads (that’s not a typo…that’s what a fly is…a spread of spreads. Prove it to yourself with a pencil and paper), are zeros.
The market places very little probability density at high prices, but this is very jarring to people who see the jacked call premiums.
That’s not an opportunity. It’s a sucker bet.
I kept that last line in the block quote because it made me laugh. It sounds so AI, but this article was written years before ChatGPT was born, and I think Sam Altman owes me shares of OAI.
Anyway, it was comforting to see Jeff affirm 25 years later what I consider to be evergreen knowledge. So much of the value of options comes from being able to understand the shape of risk, which a 2-D stock price fails to convey.
If interested in learning more:
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I wrote about hearing that talk in Option Theory As A Pillar Of Decision-Making
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The best explanation I think I’ve done on the topic is my presentation on Excess Returns The Lie Your Stock’s Price is Telling You.
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And this week’s podcast notes with the Maymin brothers includes current, practical examples of using option surface information to inform position sizing