Honest Mirrors

I liked this post by Morgan Housel:

✍️How People Think (29 min read)

He explains:

This article describes 17 of what I think are the most common and influential aspects of how people think.

It’s a long post, but each point can be read individually. Skip the ones you don’t agree with and reread the ones you do – that itself is a common way people think.

My obsessive need to consolidate and refactor required transposing his list to this one (I re-titled them all for compression):

1) Tribalism

2) We only see the tip of icebergs

3) All probability gets represented as yes or no

4 and 5) We expect trees to grow to the sky (which leads us to overreaction)

6) We are surprised when geniuses disappoint us

7) Unhealthy competition makes us short-sighted. The antidote is extending the horizon to create space.

8) Stories FTW

9) Complexity sells

10) Motivated reasoning is the rule

11) Experience is the raw material for empathy

12) Heisenberg makes us poor self-evaluators. Seek other’s input

13 and 16) Innumerate about extremes [compounding & inevitably of rare occurrences ie the birthday problem]

14) Simple but not easy

15) When imagining change we fail to consider the full context [for example when you are younger you imagine being older as your current life with grey hair but you don’t consider the mental and emotional evolution that comes with aging]

17) Idealism is seductive but counterproductive often leading to isolated demands for rigor

I want to zoom in on #7. It’s our child-eating friend Moloch again. I covered him several times this year:

Recall how Moloch symbolizes the tendency to overoptimize on a single value to the detriment of all others, swallowing everyone in its unhealthy path.

I tend to be pretty laid back in general. For better or worse, I tend to be a satisficer rather than a maximizer. A charitable interpretation of that trait (there are non-charitable ones too but I’m the host of this here party at the Moontower) is I appreciate ergodicity. See Luca Dellanna’s What Is Ergodicity? for a quick explanation that word.

But it turns out, humans likely grok the idea in their DNA. In fact, this appreciation forms the basis of pushback against some of the cognitive bias research, especially loss aversion. Contrived behavioral economics experiments assume agents maximize single-trial expected value instead of median expectancy. What behavioral economists label as design flaws are more of Chesterton’s Fence to protect you from self-destruction in the name of maximization. The expected value of saved seconds from jayrunning across the street might be positive. But you only need one ill-timed fall to negate the sum of those optimized moments.

So when I say that “slack” is the answer to Moloch, it has nothing to do with being lazy. It’s appreciating that any one trial is just a single draw in a repeated strategy and the merits of the strategy cannot be graded on isolated outcomes.

Since we are on the topic of behavioral economics, there is another common knock against cognitive bias research.

Via Notes From Todd Simkin On The Knowledge Project:

Shane points out a paradox in cognitive science. Knowing our biases doesn’t seem to help us overcome them.

Todd concurs:

It is definitely true that it is sort of descriptive of the past. A lot of these heuristics and biases are things that we can see when we after we’ve already identified that a mistake has been made. And we say, Okay, well, why was the mistake made? Say, oh, because I was anchored, or because of the way the question was framed, or whatever it might be, we have a really hard time seeing it in ourselves.

But we know the cure for this. I wrote:

This is a topic the brilliant Ced Chin has studied in depth. Ced told me that the literature suggests the only way cognitive bias inoculation works is via group reinforcement. I told him that was exactly the cultural DNA when I was at SIG which makes me believe there is a lot of value in being aware of bias. Anytime you replayed your decision process, it was a cultural norm to point out where in the process you were prone to bias.

Todd reinforces Ced’s conclusions:

We have a really easy time seeing when someone else is making that type of stupid mistake. A big part of our approach to education is to teach people to talk through their decisions, and to end to talk about why they’re doing what they’re doing with their peers, the other people on their team. If we can do that real-time, that’s great. Often in trading, you don’t have that opportunity, because things are just too immediate. But certainly, anytime things have changed. If you’re doing things differently, it’s a really good time to turn to the traders around you. And the quantitative researchers around you and the assistant traders and your team and say, Hmm, it looks like all the sudden Gamestop is a whole lot more volatile than it was a week ago. Here’s how I’m positioning for this trading. What do you guys think? And have someone say, oh, it seems like you’re really anchored to last week’s volatility. If things have changed that much, you need to move much more quickly than you’re moving right now.So you don’t realize that you’re anchored, that’s the whole nature of being anchored, is that you don’t recognize the outsized importance that the anchor has on your decision, but somebody else who’s a little bit more distant from it can. So if we’re good at encouraging communication, then we’re going to be really good at getting other people to help improve your decision process.

I add:

There it is. The key — communication. It’s not some magic formula. Even after I left SIG I spent my whole career working with SIG alum. This culture and these types of communications happen all day on the desk. Despite the common perceptions of “trading”, I have always found it to be a team game and communication skills are paramount.

Todd expands:

I know that you are fond of pointing out that you are the sum of the five people that you spend the most time with. So if the people that you’re spending the most time with are your co-workers who are thinking about trading the same way you are, then maybe you’re going to combine the same types of errors, it’s certainly better than then trying to act on your own. But even better is if you have a culture that rewards truth-finding, as opposed to rewarding action. If nobody feels personally attacked, because of somebody else pointing out their error, but instead feels like we together have now done more to get closer to, to some truth to the better way to act or the you know, the more accurate, fair value of this asset that we’re trading, then everybody feels like it’s a win. And they will therefore encourage the involvement of the people around them.

If you work in a Molochian, credit-stealing environment you face a prisoner’s dilemma as to whether you even want to even correct others’ biases. (I suspect this gets worse as the fiefdoms that emerge in large hierarchies rot the spirit from the inside). Teamwork and its antecedent, alignment, are devilishly hard, but critical because they hold the key to improving decisions.

When Shane asks what the most important variables are for being a better decision-maker, he expects Todd might say “probabilistic thinking”. But Todd did not hesitate with his answer:

Talk more is number one, that beats probabilistic thinking. That beats sort of anything else. Truth-finding is being able to bring in other people in the decision process in a constructive way. So finding good ways to communicate, to improve the input from others. Thinking probabilistically I think is definitely a very, very important piece of trying to diagnose what works by trying to think of where where things fall apart, where people fail. The other place that people fail is falling in love with their decision process and not being open to being wrong. So an openness to feedback to finding disconfirming information to actively seeking out disconfirming information, which is really uncomfortable. But that I think is the other piece that is super important for being a good trader.

If I were to try to be a prop trader from my pajamas, I’d form a Discord channel of sharp, open-minded, truth-seeking, humble, teachable teammates before I even opened a brokerage account.

Trading is not a single-player game.

You need honest mirrors. Not the ones you find in fancy dressing rooms.

Stay groovy squad

Itchy Blankets

Last week I hinted at a framework for deciding what to pursue if you started with a blank sheet of paper.

Before I continue, I want to briefly address headspace. As we travel through life there are periods where we are head down with specific outcomes in mind. It could be printing money at your job, training for a marathon, building a business, surviving residency, or writing a thesis. Whether consumed by a grueling grind or a creative fever, it’s not the time for introspection.

Don’t interrupt momentum in between checkpoints. Even if it’s a slog, be gracious for the conviction. It’s a gift that comes and goes. Don’t squander it. Just like true learning, personal progress is uncomfortable. Ron Burgundy said it best — “it’s a deep burn”. The only way is through.

Conversely, if you are at a checkpoint, looking for your next sprint, you’re in explore mode looking for your next exploit. I don’t love the word exploit here but it’s a classic framing of the problem (see my notes on an interview with AI researcher Brian Christian). Part of that search is self-search. “Why” overtakes “how”. If this is where you find yourself, I hope this essay offers a perspective to turn over in your mind. If you are full speed ahead on your current jam, you can skip ahead to today’s Money Angle.

Otherwise, let’s make our way toward the framework.

It comes from a meatspace friend who I admire for a brutal amount of intent in how he lives. He’s not an online guy but has one of the Tim Urban visuals from The Tail End printed out in his office. I have an offline in-law who has the number of weekends he has left with his kids on the front page of his digital dashboard. Besides being impressed with Tim Urban’s reach, I’m struck at how conscious these people are about time. I remember listening to an interview with investor Chris Cole where he talks about the watch he wears — it counts the days until his expected actuarial death.

Personally, I don’t feel compelled to inhabit this level of morbidity, but I can appreciate its life-affirming focus. If they sound quasi-extreme, it’s only because it’s easy to take time for granted. But you can’t put more sand in an hourglass1.

Acknowledge Your Agency

Complacency is a warm blanket. It soothes and coddles. Until you get itchy. Then it becomes the very source of your discomfort. Once you notice, you can’t get it off fast enough.

Agency is choosing which discomfort you want to confront. Fear or complacency. Fear of what? I don’t even want to type it out because it sounds ridiculous, but here it goes:

You are afraid of your own potential.

It still sounds ridiculous. So why indulge the thought? Two reasons.

  1. If it’s true, then finding out has an outrageous expected value in terms of fulfillment.I doubt fulfillment is a destination. It’s more of the feeling of pushing against something and having it push back in a way that makes you feel like you are alive. That you are in a conversation with existence rather than just watching it.
  2. Others have this thought as well. And that’s a clue that it could be real and worth confronting.

As evidence of this second thought, I strongly urge you to read the entirety of Nat Eliason’s short post:

✍️Shadow Careers and Unembracing Failure (4 min read)

I want to zoom in specifically on the back half of the post (boldfaced is mine):

We should want to work on things where failing terrifies us. If you feel nothing when a relationship ends, why were you in it in the first place? If you wouldn’t be devastated by failing to succeed at your mission, what kind of mission are you spending your limited years pursuing?

It’s a bit lofty, sure, but it provides a useful heuristic. Assuming your basic needs are met it might not be worth working on anything where you aren’t terrified of failing. If you know a project is going to succeed, or you’d be fine if it failed, then it’s not a true calling for you.

There’s a concept I think about from time to time, that hell would be meeting the person you could have been. Who you could be if you ignored the shadow careers, the side quests, the failures you were okay with.

Imagining that person can often be helpful. You’ll almost immediately fill in certain gaps, probably related to what you’re most insecure about. What would you expect them to say they did? What would they tell you they accomplished that would make you immediately overcome with self-loathing at your own shortcomings?

I know my answers, and I bet you do too. It’s not fun to think about, but it is certainly useful. Most of us are in shadow careers. Shadow careers are the defaults. We have to spend some time imagining that person, seeing what they could say that would make us the most embarrassed, to start to tap into a potential level of fulfillment we’re passing up for what’s easy.

“What happens when we turn pro is, we finally listen to that still, small voice inside our heads. At last, we find the courage to identify the secret dream or love or bliss that we have known all along was our passion, our calling, our destiny.”

And lest it gets confused, achieving these secret dreams won’t bring any lasting happiness. Finding the right challenge to struggle against, though… that’s a game you can play for life.


Framework

So back to the “framework” I keep mentioning. Its purpose is to take our ridiculous premise and map it to target opportunities. We want to find the “right challenge to struggle against”.

To do that, we find the overlap of 3 concepts:

  • Constraints
  • Terms
  • Worldview

Constraints

These are your “must-haves”. For example, your endeavor must satisfy or have an acceptable chance of satisfying your financial and geographic needs. You must account for your family’s needs. It sounds straightforward because these are conversations you should have already had but it’s worth checking assumptions. If you define your constraints too narrowly you will rob yourself of paths. This step carries the risk of guiding the Ouija board right back to where you are now by making it the only choice.

Terms

This is similar to constraints but more aspirational. These map to “nice to haves” but without the “take it or leave it” air of negotiability that phrase carries. There’s urgency here. If your terms are not serious goals, why bother with this exercise in the first place?

What’s an example of a term?

A basic example is genuinely liking what you do. Being excited to work. Another example is defining how much time you spend with your kids. Imagine what you want that to look like. This is not easy because “time with kids” is a complicated idea. Some parts of it are a drag. This is not a time to let guilt define your terms. We all have different levels of patience. Some parents prefer their kids in smaller doses than others. It’s ok. Be honest with yourself.

If this reflection isn’t mentally or emotionally demanding you are not doing it right. At the same time, there needs to be flexibility. We don’t have perfect track records of predicting what we want.

Worldview

This one is a doozy because it’s something I’ve only started thinking about in the past few years directly. And some part of that is because I didn’t realize it was ok to have worldviews. Or maybe I just didn’t find it useful to be anything other than agnostic about everything. This has been gradually changing. While I’m not interested in spelling my worldviews out, you can spot some of them by reading between the lines of this letter every week.

Still, I want to be more concrete about what worldview means. I will share my friend’s as an example. He was happy to lay them out for me (and if any local friends are reading this there’s a decent chance they can figure out who it is. He lives it.)

His life and work place an emphasis on 3 aspects of life that he never tires of exploring. To him, they hold the keys to human flourishing.

  1. Culture/Identity
  2. Community
  3. Learning

His hobbies and businesses orbits these three ideas. It’s not an accident. His ethnicity and religion are visibly different than what you typically find growing up south of the Mason-Dixon line as he did. He spent time touring the world as part of a band you likely know. These experiences shaped his worldview. His most recent startup was born out of things he was already doing with his 3 kids. Prior businesses were born out of community building.

Wordviews, like terms and constraints, are deeply personal. I only shared the ones above for example. Your own views can be miles apart. This pluralism is the basis for both bonds and frictions. This leads to an interaction between the three concepts. Your terms or constraints may preclude you from exposure to certain worldviews. The truth is there are some worldviews you are never building a bridge towards.

But the stakes aren’t always that high. We make compromises.

You can spend 8-10 hours a day unaligned with your collaborators’ views or doing work out of sync with your own views. If your choices are limited, your tolerance for this might be high. It’s a tough spot to be in. If you are fortunate enough to have options then a sense of alienation will gradually gnaw at you. You might tolerate it. You might rationalize. You’ll definitely compartmentalize.

Until a point.

The cost of that self-alienation builds. I once had a colleague, older than me, both seasoned and successful who quit because dealing with brokers all day (in a prior gig he purely focused on electronic trading) affected him negatively. He couldn’t compartmentalize. “I’m not who I want to be when I’m here”. I will never forget when he left. If I were 25, I would have thought “what a soft thing to say… suck it up”. Instead, I have profound respect for his choice. I suspect it cost him a lot of money.

You may believe it’s a luxury to adhere to your values. The logic reminds me of how Milton Friedman theorized that racism would be self-correcting because if a bigot chose to not sell products to or hire from a segment of the population the bigot would hurt themselves. I think Friedman was wrong because he was assuming that dollars were the sum of our values. Similarly, your values might cost you dollars, but your soul feels the cost when you ignore your values.

[That reminds me — one of my worldviews is that accounting is super important. Because what we measure gets managed, accounting is actually the art of representing the full picture of costs and benefits. Since decisions in all aspects of life are downstream of accounting, we need to measure better. We need holistic accounting. If your heart and body “disagree” with an outcome that was supposed to make you happy, I suspect your decisions fell out of a narrow accounting framework.

So I lied. I did share a worldview.]

Ok, this is getting long and I’m feeling pedantic. I mentioned last week that I’m still working through stuff. I know this might all sound a bit pompous and snowflakey. I’ll never apologize for snowflakism (another worldview in there probably). But I also appreciate that many people are dutiful without overthinking. Life can sometimes feel like a parade of sterile transactions that pay the bills. There’s grace in just being reliable. The older I get the more inspired I am by the unsung elders who just get it done without too much introspection. There’s tremendous beauty in that and they don’t even realize it.

But this essay is for those trying to sleep in an itchy blanket. It’s warm but you’ll never rest.

Living is risk. Your potential is indeed fearsome. March straight into it if you want to live.

“When in doubt, have a man come through a door with a gun in his hand.”

-Raymond Chandler’s advice to writers who get stuck


Further reading:

✍️How to Pick a Career That Actually Fits You (60 min read)

This is another Tim Urban classic. He penned it in 2018. In a pensive weekend, while Yinh was at Coachella I actually printed out the worksheets and worked though them while I streamed the festival on YouTube. I forgot the name of the post but was able to search for it according to how I remembered it — as the “octopus” model.

The resources at the end are also worth checking out, especially 80,000 Hours. Tim describes it as:

dedicated to helping young, high-potential people make big career choices—is an awesome resource. The site is run by super smart, thoughtful, forward-thinking people, and can be digested in video or book format in addition to on their site.

Moontower #146

Friends,

Last week I hinted at a framework for deciding what to pursue if you started with a blank sheet of paper.

Before I continue, I want to briefly address headspace. As we travel through life there are periods where we are head down with specific outcomes in mind. It could be printing money at your job, training for a marathon, building a business, surviving residency, or writing a thesis. Whether consumed by a grueling grind or a creative fever, it’s not the time for introspection.

Don’t interrupt momentum in between checkpoints. Even if it’s a slog, be gracious for the conviction. It’s a gift that comes and goes. Don’t squander it. Just like true learning, personal progress is uncomfortable. Ron Burgundy said it best — “it’s a deep burn”. The only way is through.

Conversely, if you are at a checkpoint, looking for your next sprint, you’re in explore mode looking for your next exploit. I don’t love the word exploit here but it’s a classic framing of the problem (see my notes on an interview with AI researcher Brian Christian). Part of that search is self-search. “Why” overtakes “how”. If this is where you find yourself, I hope this essay offers a perspective to turn over in your mind. If you are full speed ahead on your current jam, you can skip ahead to today’s Money Angle.

Otherwise, let’s make our way toward the framework.

It comes from a meatspace friend who I admire for a brutal amount of intent in how he lives. He’s not an online guy but has one of the Tim Urban visuals from The Tail End printed out in his office. I have an offline in-law who has the number of weekends he has left with his kids on the front page of his digital dashboard. Besides being impressed with Tim Urban’s reach, I’m struck at how conscious these people are about time. I remember listening to an interview with investor Chris Cole where he talks about the watch he wears — it counts the days until his expected actuarial death.

Personally, I don’t feel compelled to inhabit this level of morbidity, but I can appreciate its life-affirming focus. If they sound quasi-extreme, it’s only because it’s easy to take time for granted. But you can’t put more sand in an hourglass1.

Acknowledge Your Agency

Complacency is a warm blanket. It soothes and coddles. Until you get itchy. Then it becomes the very source of your discomfort. Once you notice, you can’t get it off fast enough.

Agency is choosing which discomfort you want to confront. Fear or complacency. Fear of what? I don’t even want to type it out because it sounds ridiculous, but here it goes:

You are afraid of your own potential.

It still sounds ridiculous. So why indulge the thought? Two reasons.

  1. If it’s true, then finding out has an outrageous expected value in terms of fulfillment.

    I doubt fulfillment is a destination. It’s more of the feeling of pushing against something and having it push back in a way that makes you feel like you are alive. That you are in a conversation with existence rather than just watching it.

  2. Others have this thought as well. And that’s a clue that it could be real and worth confronting.

As evidence of this second thought, I strongly urge you to read the entirety of Nat Eliason’s short post:

✍️Shadow Careers and Unembracing Failure (4 min read)

I want to zoom in specifically on the back half of the post (boldfaced is mine):

We should want to work on things where failing terrifies us. If you feel nothing when a relationship ends, why were you in it in the first place? If you wouldn’t be devastated by failing to succeed at your mission, what kind of mission are you spending your limited years pursuing?

It’s a bit lofty, sure, but it provides a useful heuristic. Assuming your basic needs are met it might not be worth working on anything where you aren’t terrified of failing. If you know a project is going to succeed, or you’d be fine if it failed, then it’s not a true calling for you.

There’s a concept I think about from time to time, that hell would be meeting the person you could have been. Who you could be if you ignored the shadow careers, the side quests, the failures you were okay with.

Imagining that person can often be helpful. You’ll almost immediately fill in certain gaps, probably related to what you’re most insecure about. What would you expect them to say they did? What would they tell you they accomplished that would make you immediately overcome with self-loathing at your own shortcomings?

I know my answers, and I bet you do too. It’s not fun to think about, but it is certainly useful. Most of us are in shadow careers. Shadow careers are the defaults. We have to spend some time imagining that person, seeing what they could say that would make us the most embarrassed, to start to tap into a potential level of fulfillment we’re passing up for what’s easy.

“What happens when we turn pro is, we finally listen to that still, small voice inside our heads. At last, we find the courage to identify the secret dream or love or bliss that we have known all along was our passion, our calling, our destiny.”

And lest it gets confused, achieving these secret dreams won’t bring any lasting happiness. Finding the right challenge to struggle against, though… that’s a game you can play for life.


Framework

So back to the “framework” I keep mentioning. Its purpose is to take our ridiculous premise and map it to target opportunities. We want to find the “right challenge to struggle against”.

To do that, we find the overlap of 3 concepts:

  • Constraints
  • Terms
  • Worldview

Constraints

These are your “must-haves”. For example, your endeavor must satisfy or have an acceptable chance of satisfying your financial and geographic needs. You must account for your family’s needs. It sounds straightforward because these are conversations you should have already had but it’s worth checking assumptions. If you define your constraints too narrowly you will rob yourself of paths. This step carries the risk of guiding the Ouija board right back to where you are now by making it the only choice.

Terms

This is similar to constraints but more aspirational. These map to “nice to haves” but without the “take it or leave it” air of negotiability that phrase carries. There’s urgency here. If your terms are not serious goals, why bother with this exercise in the first place?

What’s an example of a term?

A basic example is genuinely liking what you do. Being excited to work. Another example is defining how much time you spend with your kids. Imagine what you want that to look like. This is not easy because “time with kids” is a complicated idea. Some parts of it are a drag. This is not a time to let guilt define your terms. We all have different levels of patience. Some parents prefer their kids in smaller doses than others. It’s ok. Be honest with yourself.

If this reflection isn’t mentally or emotionally demanding you are not doing it right. At the same time, there needs to be flexibility. We don’t have perfect track records of predicting what we want.

Worldview

This one is a doozy because it’s something I’ve only started thinking about in the past few years directly. And some part of that is because I didn’t realize it was ok to have worldviews. Or maybe I just didn’t find it useful to be anything other than agnostic about everything. This has been gradually changing. While I’m not interested in spelling my worldviews out, you can spot some of them by reading between the lines of this letter every week.

Still, I want to be more concrete about what worldview means. I will share my friend’s as an example. He was happy to lay them out for me (and if any local friends are reading this there’s a decent chance they can figure out who it is. He lives it.)

His life and work place an emphasis on 3 aspects of life that he never tires of exploring. To him, they hold the keys to human flourishing.

  1. Culture/Identity
  2. Community
  3. Learning

His hobbies and businesses orbits these three ideas. It’s not an accident. His ethnicity and religion are visibly different than what you typically find growing up south of the Mason-Dixon line as he did. He spent time touring the world as part of a band you likely know. These experiences shaped his worldview. His most recent startup was born out of things he was already doing with his 3 kids. Prior businesses were born out of community building.

Wordviews, like terms and constraints, are deeply personal. I only shared the ones above for example. Your own views can be miles apart. This pluralism is the basis for both bonds and frictions. This leads to an interaction between the three concepts. Your terms or constraints may preclude you from exposure to certain worldviews. The truth is there are some worldviews you are never building a bridge towards.

But the stakes aren’t always that high. We make compromises.

You can spend 8-10 hours a day unaligned with your collaborators’ views or doing work out of sync with your own views. If your choices are limited, your tolerance for this might be high. It’s a tough spot to be in. If you are fortunate enough to have options then a sense of alienation will gradually gnaw at you. You might tolerate it. You might rationalize. You’ll definitely compartmentalize.

Until a point.

The cost of that self-alienation builds. I once had a colleague, older than me, both seasoned and successful who quit because dealing with brokers all day (in a prior gig he purely focused on electronic trading) affected him negatively. He couldn’t compartmentalize. “I’m not who I want to be when I’m here”. I will never forget when he left. If I were 25, I would have thought “what a soft thing to say… suck it up”. Instead, I have profound respect for his choice. I suspect it cost him a lot of money.

You may believe it’s a luxury to adhere to your values. The logic reminds me of how Milton Friedman theorized that racism would be self-correcting because if a bigot chose to not sell products to or hire from a segment of the population the bigot would hurt themselves. I think Friedman was wrong because he was assuming that dollars were the sum of our values. Similarly, your values might cost you dollars, but your soul feels the cost when you ignore your values.

[That reminds me — one of my worldviews is that accounting is super important. Because what we measure gets managed, accounting is actually the art of representing the full picture of costs and benefits. Since decisions in all aspects of life are downstream of accounting, we need to measure better. We need holistic accounting. If your heart and body “disagree” with an outcome that was supposed to make you happy, I suspect your decisions fell out of a narrow accounting framework.

So I lied. I did share a worldview.]

Ok, this is getting long and I’m feeling pedantic. I mentioned last week that I’m still working through stuff. I know this might all sound a bit pompous and snowflakey. I’ll never apologize for snowflakism (another worldview in there probably). But I also appreciate that many people are dutiful without overthinking. Life can sometimes feel like a parade of sterile transactions that pay the bills. There’s grace in just being reliable. The older I get the more inspired I am by the unsung elders who just get it done without too much introspection. There’s tremendous beauty in that and they don’t even realize it.

But this essay is for those trying to sleep in an itchy blanket. It’s warm but you’ll never rest.

Living is risk. Your potential is indeed fearsome. March straight into it if you want to live.

“When in doubt, have a man come through a door with a gun in his hand.”

-Raymond Chandler’s advice to writers who get stuck


Further reading:

✍️How to Pick a Career That Actually Fits You (60 min read)

This is another Tim Urban classic. He penned it in 2018. In a pensive weekend, while Yinh was at Coachella I actually printed out the worksheets and worked though them while I streamed the festival on YouTube. I forgot the name of the post but was able to search for it according to how I remembered it — as the “octopus” model.

The resources at the end are also worth checking out, especially 80,000 Hours. Tim describes it as:

dedicated to helping young, high-potential people make big career choices—is an awesome resource. The site is run by super smart, thoughtful, forward-thinking people, and can be digested in video or book format in addition to on their site.


Money Angle

I liked this post by Morgan Housel:

✍️How People Think (29 min read)

He explains:

This article describes 17 of what I think are the most common and influential aspects of how people think.

It’s a long post, but each point can be read individually. Skip the ones you don’t agree with and reread the ones you do – that itself is a common way people think.

My obsessive need to consolidate and refactor required transposing his list to this one (I re-titled them all for compression):

1) Tribalism

2) We only see the tip of icebergs

3) All probability gets represented as yes or no

4 and 5) We expect trees to grow to the sky (which leads us to overreaction)

6) We are surprised when geniuses disappoint us

7) Unhealthy competition makes us short-sighted. The antidote is extending the horizon to create space.

8) Stories FTW

9) Complexity sells

10) Motivated reasoning is the rule

11) Experience is the raw material for empathy

12) Heisenberg makes us poor self-evaluators. Seek other’s input

13 and 16) Innumerate about extremes [compounding & inevitably of rare occurrences ie the birthday problem]

14) Simple but not easy

15) When imagining change we fail to consider the full context [for example when you are younger you imagine being older as your current life with grey hair but you don’t consider the mental and emotional evolution that comes with aging]

17) Idealism is seductive but counterproductive often leading to isolated demands for rigor

I want to zoom in on #7. It’s our child-eating friend Moloch again. I covered him several times this year:

Recall how Moloch symbolizes the tendency to overoptimize on a single value to the detriment of all others, swallowing everyone in its unhealthy path.

I tend to be pretty laid back in general. For better or worse, I tend to be a satisficer rather than a maximizer. A charitable interpretation of that trait (there are non-charitable ones too but I’m the host of this here party at the Moontower) is I appreciate ergodicity. See Luca Dellanna’s What Is Ergodicity? for a quick explanation that word.

But it turns out, humans likely grok the idea in their DNA. In fact, this appreciation forms the basis of pushback against some of the cognitive bias research, especially loss aversion. Contrived behavioral economics experiments assume agents maximize single-trial expected value instead of median expectancy. What behavioral economists label as design flaws are more of Chesterton’s Fence to protect you from self-destruction in the name of maximization. The expected value of saved seconds from jayrunning across the street might be positive. But you only need one ill-timed fall to negate the sum of those optimized moments.

So when I say that “slack” is the answer to Moloch, it has nothing to do with being lazy. It’s appreciating that any one trial is just a single draw in a repeated strategy and the merits of the strategy cannot be graded on isolated outcomes.

Since we are on the topic of behavioral economics, there is another common knock against cognitive bias research.

Via Notes From Todd Simkin On The Knowledge Project:

Shane points out a paradox in cognitive science. Knowing our biases doesn’t seem to help us overcome them.

Todd concurs:

It is definitely true that it is sort of descriptive of the past. A lot of these heuristics and biases are things that we can see when we after we’ve already identified that a mistake has been made. And we say, Okay, well, why was the mistake made? Say, oh, because I was anchored, or because of the way the question was framed, or whatever it might be, we have a really hard time seeing it in ourselves.

But we know the cure for this. I wrote:

This is a topic the brilliant Ced Chin has studied in depth. Ced told me that the literature suggests the only way cognitive bias inoculation works is via group reinforcement. I told him that was exactly the cultural DNA when I was at SIG which makes me believe there is a lot of value in being aware of bias. Anytime you replayed your decision process, it was a cultural norm to point out where in the process you were prone to bias.

Todd reinforces Ced’s conclusions:

We have a really easy time seeing when someone else is making that type of stupid mistake. A big part of our approach to education is to teach people to talk through their decisions, and to end to talk about why they’re doing what they’re doing with their peers, the other people on their team. If we can do that real-time, that’s great. Often in trading, you don’t have that opportunity, because things are just too immediate. But certainly, anytime things have changed. If you’re doing things differently, it’s a really good time to turn to the traders around you. And the quantitative researchers around you and the assistant traders and your team and say, Hmm, it looks like all the sudden Gamestop is a whole lot more volatile than it was a week ago. Here’s how I’m positioning for this trading. What do you guys think? And have someone say, oh, it seems like you’re really anchored to last week’s volatility. If things have changed that much, you need to move much more quickly than you’re moving right now.So you don’t realize that you’re anchored, that’s the whole nature of being anchored, is that you don’t recognize the outsized importance that the anchor has on your decision, but somebody else who’s a little bit more distant from it can. So if we’re good at encouraging communication, then we’re going to be really good at getting other people to help improve your decision process.

I add:

There it is. The key — communication. It’s not some magic formula. Even after I left SIG I spent my whole career working with SIG alum. This culture and these types of communications happen all day on the desk. Despite the common perceptions of “trading”, I have always found it to be a team game and communication skills are paramount.

Todd expands:

I know that you are fond of pointing out that you are the sum of the five people that you spend the most time with. So if the people that you’re spending the most time with are your co-workers who are thinking about trading the same way you are, then maybe you’re going to combine the same types of errors, it’s certainly better than then trying to act on your own. But even better is if you have a culture that rewards truth-finding, as opposed to rewarding action. If nobody feels personally attacked, because of somebody else pointing out their error, but instead feels like we together have now done more to get closer to, to some truth to the better way to act or the you know, the more accurate, fair value of this asset that we’re trading, then everybody feels like it’s a win. And they will therefore encourage the involvement of the people around them.

If you work in a Molochian, credit-stealing environment you face a prisoner’s dilemma as to whether you even want to even correct others’ biases. (I suspect this gets worse as the fiefdoms that emerge in large hierarchies rot the spirit from the inside). Teamwork and its antecedent, alignment, are devilishly hard, but critical because they hold the key to improving decisions.

When Shane asks what the most important variables are for being a better decision-maker, he expects Todd might say “probabilistic thinking”. But Todd did not hesitate with his answer:

Talk more is number one, that beats probabilistic thinking. That beats sort of anything else. Truth-finding is being able to bring in other people in the decision process in a constructive way. So finding good ways to communicate, to improve the input from others. Thinking probabilistically I think is definitely a very, very important piece of trying to diagnose what works by trying to think of where where things fall apart, where people fail. The other place that people fail is falling in love with their decision process and not being open to being wrong. So an openness to feedback to finding disconfirming information to actively seeking out disconfirming information, which is really uncomfortable. But that I think is the other piece that is super important for being a good trader.

If I were to try to be a prop trader from my pajamas, I’d form a Discord channel of sharp, open-minded, truth-seeking, humble, teachable teammates before I even opened a brokerage account.

Trading is not a single-player game.

You need honest mirrors. Not the ones you find in fancy dressing rooms.

Stay groovy squad

Can Your Manager Solve Betting Games With Known Solutions?

One of the best threads I’ve seen in a while. It’s important because it shows how betting strategies vary based on your goals.

In the basic version, the “Devil’s Card Game” is constrained by the rule that you must bet your entire stack each time.

You can maximize:

  1. expectation
  2. utility (in the real world Kelly sizing is the instance of this when utility follows a log function)
  3. the chance of a particular outcome.

At the end of the thread, we relax the bet sizing rules and allow the player to bet any fraction of the bankroll they’d like. This is a key change.

It leads to a very interesting strategy called backward induction. In markets, the payoffs are not well-defined. But this game features a memory because it is a card game without replacement. Like blackjack. You can count the possibilities.

The thread shows how the backward induction strategy blows every other strategy out of the water.

If we generalize this, you come upon a provocative and possibly jarring insight:

The range of expectations simply based on betting strategies is extremely wide.

That means a good proposition can be ruined by an incompetent bettor. Likewise, a poor proposition can be somewhat salvaged by astute betting.

I leave you with musings.

  1. Is it better to pair a skilled gambler with a solid analyst or the best analyst with a mid-brow portfolio manager?
  2. How confident are you that the people who manage your money would pick the right betting strategy for a game with a known solution?Maybe allocators and portfolio managers should have to take gambling tests. If analytic superiority is a source of edge, the lack of it is not simply an absence of one type of edge. It’s actually damning because it nullifies any other edge over enough trials assuming markets are competitive (last I checked that was their defining feature).

Why I Share Online And The Decision To Leave Trading

Friends,

Soooo…getting back into the groove after vacation has been a failure. Been hard to conjure any productivity. While I was in Hawaii, I left my phone in the room most of the time. Was nice to mostly unplug. But vacation is fantasyland and then you come home. Instead of building on a healthy habit, I gave myself permission to guiltlessly hang out on Twitter as if I earned something. My history of swallowing a pint of ice cream after the rare cardio session is ample warning that in my personal constitution no good deed goes unpunished.

The upshot of all this?

Instead of having some tidy, prepared essay I’m gonna just overshare about life today. If you’re here for nerd stuff feel free to skip ahead to Money Angle, no hard feelings.

Ok. So there was a Twitter thread where a friend and a stranger were talking about me. The stranger was asking the friend why a portfolio manager (don’t mind me as I adjust my imaginary tie) would share insight about trading publicly. The tone, insofar as one can detect tone in text, was “traders shut up and trade, grifters teach”.

It’s not the first time I’ve seen something like that and I usually let it slide. I suspect I normally don’t get too much suspicion directed at me because it would be really hard to fake 21 years of prop trading with a massive sample size of daily trades and then write about risk and options in a way that other verified pros find value in. This is not me defending myself. This is you, beloved readers, especially the professional peers amongst you who are so supportive.

But this particular conversation did spark a reaction in me because it was a friend that was stuck in some isolated thread trying to defend me. So I chimed in to give him a break.

This is how I think about my writing about trading:

If you are a pro options trader reading me, then I’m reinforcing what you already know. Sometimes the articulation gives you a vocabulary that clarifies your thinking. I’m not turning over new rocks, but if I scramble them a bit, you may see something new.

If you are a novice trader/investor, you are learning things that are table stakes for the risk-taking side of the industry. The decision-making principles are not secrets. You can find any number of sources to learn from. People prefer to be communicated to in different ways. I’m just one of those many ways.

I would never write about secrets while I was working. I chose to write about the meta. The website is literally called MoontowerMeta. So if you are not violating any policies, you’re not exposing info that your friends use to make money, and you can still find angles that are helpful to readers then you have value to share. Aspiring writers sitting on trading desks, that’s your cue.

[An aside that is gonna trigger some set of people: I could hand over all my professional dashboards and tools, and it wouldn’t make a difference. You won’t get the same results. Experience, discipline, and creativity are not something you can take from another. And they are foundational to a discretionary strategy. Think about this from a game-theoretic point of view. If I could codify (I tried and couldn’t) what I did, then it would be easy to prove the edge. The strategy would then be automated and be oversubscribed or its owners would never sell it to an investor. The fact that it’s discretionary and cannot be proven except by its eventual outcomes means an investor must always worry that I’m full of shit. But that’s also why there’s some middle ground where I want outside funding and investors are willing to fund it. If a purely automated, systematic strategy is a money-printing machine you’ll never see it. And if you do, its legibility will be its eventual downfall as it gains assets]

Still, a big question remains —why share? The stranger was hinting that I had an ulterior motive. Like maybe I had flamed out and was setting up my next job. There’s some truth to that but not in the way he insinuated. (The last year of my career was my best and it was not even close.)

I decided to tweet a thread on why I share. To do that I needed to back up and explain the decision process behind quitting.

The bizarre result was the thread went totally viral. I also realized the way I wrote it must have made people think I just quit. Tsk, tsk. If they were subbing to Moontower they know that is old news. If you didn’t receive this letter in your email don’t make that mistake:

Subscribe.

Before I quit trading, I framed the decision: I’m 43 yrs old. I can stay, make more $$, racing for 10 more years. Or I can leave now, while I have energy, reasonable health and less ageism against me to work towards something that I’m not in a race to get over.

It will take some time to figure out my next step but since my kids are 5 and 8, it’s a great time to take time. When I start my second professional life, it won’t be a race. It’s something I can do til I drop dead.

I’ve written about my lack of interest in any conventional retirement (I don’t play golf, I like to work and write with my free time as long as it’s on my terms). So a sustainable journey reduces my need for a large nest egg to carry through many non-working years. (I also put little trust in market returns as an arbiter of my financial destiny so I’m conservative about how long I need to work). If you know you can work say 20 years longer than if you raced in a finance career, then a lot of pressure is relieved.

Suddenly leaving isn’t so risky.

2 other points:

1. If I stayed I’d be in the same boat at 53 years old. What do I do with myself? I’d have more money, but also so what. Money is not an issue if you are happy working (and you don’t crave caviar every meal)

2. If I’m wrong, I can always get a finance job. It won’t pay what I used to make because the seniority you have with people you know for a long time is a special sort of trust and goodwill. I had a long leash (in finance speak that probably earns you 2 years of underperformance cushion).

I prefer not to take my mortality for granted and when you are in your 40s it becomes far more real. When you receive a phone call instead of a text out of the blue your pulse quickens a bit. I don’t obsess about $ like I did even 10 years ago and definitely not like 20 years ago. I didn’t grow up with it, but have fought the urge to see it as a security blanket catch-all for every kind of anxiety.

Scarcity mindset is adaptive when you are young and broke, because the scarcity can be quite real. The mindset is protection. Like a 40d put. But as you earn, that put becomes further OTM. You are going to be ok. No need to pay theta in the form of suboptimal decisions because you feel the need to service that put as if it’s 40d when it’s really 1 delta.

Everyone gotta do what they gotta do. But if you are unhappy with your fancy job, that’s on you. There are no excuses for that. It’s understandable to feel otherwise but I do believe you need to work through that. It’s really hard to develop a healthy relationship with $. I’m trying to get better at it all the time. Because I have to. It’s not wise to do a job you don’t want to do to allay irrational fears of being broke.

Twitter is a tool for relationships and to spread proof of work. I did one thing for 21 years. When I try to do something else I’m a major underdog. I’m not going back to school. I don’t enjoy school. My online presence is like a proof of work, so when I try to convince someone to take a chance on me in a new field I can show something that looks like a resume to someone that’s open-minded. If you wonder about my incentives on Twitter, I’m being open about it: relationships, proof of work, & optionality in distribution.

There it is. I tweet and write to “find the others” and to make myself marketable to future collaborators and clients. I don’t know if that makes it any less “ulterior” if it’s not in pursuit of a trading gig (if I was going to stay in trading I already had a ridiculous seat. There are not a lot of places to go unless I was going to be a founder, but I have no interest in that. Trying to be an emerging manager is institutional masochism. Respect to my friends on that journey. I love it for them. Not for me. I know enough to never say never, but my mindset is far away from that and I’m not getting any younger.)

This thread went viral because it struck a nerve with so many people. I’m a size 150 bid on how many DMs, texts, emails, and requests for phone calls I received. Many were just extending support but many wanted to discuss their own crossroads.

If you are curious, the replies to the thread are the less vulnerable versions of private messages.

Some made similar leaps in the past, some are in the midst of such a leap, some just starting to hear the whispers from their inner selves, and some were younger people with enough maturity to already anticipate how they might feel in their 40s. It was weirdly overwhelming to get such a candid glimpse of people’s feelings.

I’m happy to discuss any aspect of all this if any of you feel that’s what you need. I had many conversations before making my final decision. One of my local friends is a serial entrepreneur a decade removed from corporate America. He’s similar in age, with a family, and is particularly thoughtful about aligning who he is with his work. Over the course of several hangouts and long morning hikes I came to understand his framework. And parts of it were foreign in interesting ways. I never considered thinking about the problem the way he does. It unlocked thoughts within me but even now I’m still processing it. It’s a bit painful to think through because you need to be so honest with yourself. If you are not rattled, you’re doing it wrong. But I knew he understood me, just based on the questions he asked. In the next week or two, I’ll discuss the framework as well as what I’m thinking about most these days.

Since it’s Twitter, a number of trolls who must hate-follow me said it was a mid-life crisis as if I was defective. I suppose I am. In many ways, it would be easier to have just stayed in my job. But if there’s a defect I’d rather take over from the autopilot and intentionally try to go to the right destination than accidentally land in the wrong one with no fuel left in the tank.


Resources

In the public domain, the 2 friends I found especially helpful were Paul Millerd and Khe Hy.

Paul’s book, Pathless Path, which came out in January is going to be canon on this topic. My notes and review are here. I’ll even buy you a copy if you want. Paul is kind and brilliant. He’s had so many discussions with others on these topics that chatting with him is like plugging yourself straight into a current of flowing wisdom.

Khe’s path was extremely resonant because he was in the same field (in fact long after he left finance I learned that he was in meetings 20 feet from where I was standing in my office). Khe’s writings make him one of the OGs about thinking about our relationships with ourselves and our careers. He has successfully navigated the long path from corporate America to a business that sustains both his clients’ and family’s needs. For the better part of a decade, his writing has put you in the sidecar. I’ve plugged his work at every opportunity because it’s outstanding and he’s the kind of giving soul you love to see crush it. The next cohort of his $10k Work Bootcamp starts in a few weeks. The testimonials are ridiculous and I’m not surprised. He’s taken everything he’s learned and combined it with easy-to-use technology to turn you into a high-leverage weapon. Give it a look hereIt’s 100% free.

Moontower #145

Friends,

Soooo…getting back into the groove after vacation has been a failure. Been hard to conjure any productivity. While I was in Hawaii, I left my phone in the room most of the time. Was nice to mostly unplug. But vacation is fantasyland and then you come home. Instead of building on a healthy habit, I gave myself permission to guiltlessly hang out on Twitter as if I earned something. My history of swallowing a pint of ice cream after the rare cardio session is ample warning that in my personal constitution no good deed goes unpunished.

The upshot of all this?

Instead of having some tidy, prepared essay I’m gonna just overshare about life today. If you’re here for nerd stuff feel free to skip ahead to Money Angle, no hard feelings.

Ok. So there was a Twitter thread where a friend and a stranger were talking about me. The stranger was asking the friend why a portfolio manager (don’t mind me as I adjust my imaginary tie) would share insight about trading publicly. The tone, insofar as one can detect tone in text, was “traders shut up and trade, grifters teach”.

It’s not the first time I’ve seen something like that and I usually let it slide. I suspect I normally don’t get too much suspicion directed at me because it would be really hard to fake 21 years of prop trading with a massive sample size of daily trades and then write about risk and options in a way that other verified pros find value in. This is not me defending myself. This is you, beloved readers, especially the professional peers amongst you who are so supportive.

But this particular conversation did spark a reaction in me because it was a friend that was stuck in some isolated thread trying to defend me. So I chimed in to give him a break.

This is how I think about my writing about trading:

If you are a pro options trader reading me, then I’m reinforcing what you already know. Sometimes the articulation gives you a vocabulary that clarifies your thinking. I’m not turning over new rocks, but if I scramble them a bit, you may see something new.

If you are a novice trader/investor, you are learning things that are table stakes for the risk-taking side of the industry. The decision-making principles are not secrets. You can find any number of sources to learn from. People prefer to be communicated to in different ways. I’m just one of those many ways.

I would never write about secrets while I was working. I chose to write about the meta. The website is literally called MoontowerMeta. So if you are not violating any policies, you’re not exposing info that your friends use to make money, and you can still find angles that are helpful to readers then you have value to share. Aspiring writers sitting on trading desks, that’s your cue.

[An aside that is gonna trigger some set of people: I could hand over all my professional dashboards and tools, and it wouldn’t make a difference. You won’t get the same results. Experience, discipline, and creativity are not something you can take from another. And they are foundational to a discretionary strategy. Think about this from a game-theoretic point of view. If I could codify (I tried and couldn’t) what I did, then it would be easy to prove the edge. The strategy would then be automated and be oversubscribed or its owners would never sell it to an investor. The fact that it’s discretionary and cannot be proven except by its eventual outcomes means an investor must always worry that I’m full of shit. But that’s also why there’s some middle ground where I want outside funding and investors are willing to fund it. If a purely automated, systematic strategy is a money-printing machine you’ll never see it. And if you do, its legibility will be its eventual downfall as it gains assets]

Still, a big question remains —why share? The stranger was hinting that I had an ulterior motive. Like maybe I had flamed out and was setting up my next job. There’s some truth to that but not in the way he insinuated. (The last year of my career was my best and it was not even close.)

I decided to tweet a thread on why I share. To do that I needed to back up and explain the decision process behind quitting.

The bizarre result was the thread went totally viral. I also realized the way I wrote it must have made people think I just quit. Tsk, tsk. If they were subbing to Moontower they know that is old news. If you didn’t receive this letter in your email don’t make that mistake:

Subscribe.

Before I quit trading, I framed the decision: I’m 43 yrs old. I can stay, make more $$, racing for 10 more years. Or I can leave now, while I have energy, reasonable health and less ageism against me to work towards something that I’m not in a race to get over.

It will take some time to figure out my next step but since my kids are 5 and 8, it’s a great time to take time. When I start my second professional life, it won’t be a race. It’s something I can do til I drop dead.

I’ve written about my lack of interest in any conventional retirement (I don’t play golf, I like to work and write with my free time as long as it’s on my terms). So a sustainable journey reduces my need for a large nest egg to carry through many non-working years. (I also put little trust in market returns as an arbiter of my financial destiny so I’m conservative about how long I need to work). If you know you can work say 20 years longer than if you raced in a finance career, then a lot of pressure is relieved.

Suddenly leaving isn’t so risky.

2 other points:

1. If I stayed I’d be in the same boat at 53 years old. What do I do with myself? I’d have more money, but also so what. Money is not an issue if you are happy working (and you don’t crave caviar every meal)

2. If I’m wrong, I can always get a finance job. It won’t pay what I used to make because the seniority you have with people you know for a long time is a special sort of trust and goodwill. I had a long leash (in finance speak that probably earns you 2 years of underperformance cushion).

I prefer not to take my mortality for granted and when you are in your 40s it becomes far more real. When you receive a phone call instead of a text out of the blue your pulse quickens a bit. I don’t obsess about $ like I did even 10 years ago and definitely not like 20 years ago. I didn’t grow up with it, but have fought the urge to see it as a security blanket catch-all for every kind of anxiety.

Scarcity mindset is adaptive when you are young and broke, because the scarcity can be quite real. The mindset is protection. Like a 40d put. But as you earn, that put becomes further OTM. You are going to be ok. No need to pay theta in the form of suboptimal decisions because you feel the need to service that put as if it’s 40d when it’s really 1 delta.

Everyone gotta do what they gotta do. But if you are unhappy with your fancy job, that’s on you. There are no excuses for that. It’s understandable to feel otherwise but I do believe you need to work through that. It’s really hard to develop a healthy relationship with $. I’m trying to get better at it all the time. Because I have to. It’s not wise to do a job you don’t want to do to allay irrational fears of being broke.

Twitter is a tool for relationships and to spread proof of work. I did one thing for 21 years. When I try to do something else I’m a major underdog. I’m not going back to school. I don’t enjoy school. My online presence is like a proof of work, so when I try to convince someone to take a chance on me in a new field I can show something that looks like a resume to someone that’s open-minded. If you wonder about my incentives on Twitter, I’m being open about it: relationships, proof of work, & optionality in distribution.

There it is. I tweet and write to “find the others” and to make myself marketable to future collaborators and clients. I don’t know if that makes it any less “ulterior” if it’s not in pursuit of a trading gig (if I was going to stay in trading I already had a ridiculous seat. There are not a lot of places to go unless I was going to be a founder, but I have no interest in that. Trying to be an emerging manager is institutional masochism. Respect to my friends on that journey. I love it for them. Not for me. I know enough to never say never, but my mindset is far away from that and I’m not getting any younger.)

This thread went viral because it struck a nerve with so many people. I’m a size 150 bid on how many DMs, texts, emails, and requests for phone calls I received. Many were just extending support but many wanted to discuss their own crossroads.

If you are curious, the replies to the thread are the less vulnerable versions of private messages.

Some made similar leaps in the past, some are in the midst of such a leap, some just starting to hear the whispers from their inner selves, and some were younger people with enough maturity to already anticipate how they might feel in their 40s. It was weirdly overwhelming to get such a candid glimpse of people’s feelings.

I’m happy to discuss any aspect of all this if any of you feel that’s what you need. I had many conversations before making my final decision. One of my local friends is a serial entrepreneur a decade removed from corporate America. He’s similar in age, with a family, and is particularly thoughtful about aligning who he is with his work. Over the course of several hangouts and long morning hikes I came to understand his framework. And parts of it were foreign in interesting ways. I never considered thinking about the problem the way he does. It unlocked thoughts within me but even now I’m still processing it. It’s a bit painful to think through because you need to be so honest with yourself. If you are not rattled, you’re doing it wrong. But I knew he understood me, just based on the questions he asked. In the next week or two, I’ll discuss the framework as well as what I’m thinking about most these days.

Since it’s Twitter, a number of trolls who must hate-follow me said it was a mid-life crisis as if I was defective. I suppose I am. In many ways, it would be easier to have just stayed in my job. But if there’s a defect I’d rather take over from the autopilot and intentionally try to go to the right destination than accidentally land in the wrong one with no fuel left in the tank.


Resources

In the public domain, the 2 friends I found especially helpful were Paul Millerd and Khe Hy.

Paul’s book, Pathless Path, which came out in January is going to be canon on this topic. My notes and review are here. I’ll even buy you a copy if you want. Paul is kind and brilliant. He’s had so many discussions with others on these topics that chatting with him is like plugging yourself straight into a current of flowing wisdom.

Khe’s path was extremely resonant because he was in the same field (in fact long after he left finance I learned that he was in meetings 20 feet from where I was standing in my office). Khe’s writings make him one of the OGs about thinking about our relationships with ourselves and our careers. He has successfully navigated the long path from corporate America to a business that sustains both his clients’ and family’s needs. For the better part of a decade, his writing has put you in the sidecar. I’ve plugged his work at every opportunity because it’s outstanding and he’s the kind of giving soul you love to see crush it. The next cohort of his $10k Work Bootcamp starts in a few weeks. The testimonials are ridiculous and I’m not surprised. He’s taken everything he’s learned and combined it with easy-to-use technology to turn you into a high-leverage weapon. Give it a look hereIt’s 100% free.


Money Angle

One of the best threads I’ve seen in a while. It’s important because it shows how betting strategies vary based on your goals.

In the basic version, the “Devil’s Card Game” is constrained by the rule that you must bet your entire stack each time.

You can maximize:

  1. expectation
  2. utility (in the real world Kelly sizing is the instance of this when utility follows a log function)
  3. the chance of a particular outcome.

At the end of the thread, we relax the bet sizing rules and allow the player to bet any fraction of the bankroll they’d like. This is a key change.

It leads to a very interesting strategy called backward induction. In markets, the payoffs are not well-defined. But this game features a memory because it is a card game without replacement. Like blackjack. You can count the possibilities.

The thread shows how the backward induction strategy blows every other strategy out of the water.

If we generalize this, you come upon a provocative and possibly jarring insight:

The range of expectations simply based on betting strategies is extremely wide.

That means a good proposition can be ruined by an incompetent bettor. Likewise, a poor proposition can be somewhat salvaged by astute betting.

I leave you with musings.

  1. Is it better to pair a skilled gambler with a solid analyst or the best analyst with a mid-brow portfolio manager?
  2. How confident are you that the people who manage your money would pick the right betting strategy for a game with a known solution?

    Maybe allocators and portfolio managers should have to take gambling tests. If analytic superiority is a source of edge, the lack of it is not simply an absence of one type of edge. It’s actually damning because it nullifies any other edge over enough trials assuming markets are competitive (last I checked that was their defining feature).


From My Actual Life

We went to the Kaanapali region of Maui for Spring Break with 4 other families.

We ended up hanging out with 13 total families that we knew, nearly half were totally random encounters. With so many friends around, the kids didn’t notice mom and dad drank their 529s in the form of Mai Tai’s.

Fun bit: this pic was taken from the backyard of a friend’s place that also has quite the poker room. The friend was renting it from a certain celeb who liked to host card nights well attended by professional athletes and…Woody Harrelson.

#goals

(If you need any recommendations let me know. Also, with rental cars so expensive Turo was the way to go for many of us.)

Stay groovy!

Finance Guilt

Finance Guilt

I’ve said several times that finance is really just code. Like software, it’s an abstraction skin pulled over physical features. One can feel a bit disembodied if their formulation of the world for 8-12 hours a day are prices. Prices that collapse all of human enterprise, from the dirt under its fingernails to the sunrises and sunsets between now and some expiration date, into some Excel number format.

Just as software intermediates for less, financial innovation lowers the cost of go-betweens. In finance, the things went-between are people paying to offload risk to people looking to get paid for warehousing risk. In software and finance, skimming a tiny bit of rent on those transactions is lucrative.

How good or bad we can feel about the degree of skimming depends on how much surplus is created versus the higher friction model. The value of information liquidity is fairly obvious so Google enjoyed a positive reputation for at least its first decade in business. Meanwhile, finance feels like a constant barrage of “what did Wells Fargo do now?” or words that rhyme with Fonzi. People outside finance can be excused for having a dim, albeit biased, view of the profession since nobody reports on people doing an honest job.

With that in mind, I leave you with Mitchell’s understandable question:

Here’s my quick response:

Agustin’s response:

I’ll wrap with a footnote from a recent post:

The slicing and dicing of risk is finance’s salutary arrow of progress. Real economic growth is human progress in its battle against entropy. By farming, we can specialize. By pooling risk, we can underwrite giant human endeavors with the risk spread out tolerably. People might not sink the bulk of their net worth into a home if it wasn’t insurable. Financial innovation is matching a hedger with the most efficient holder of the risk. It’s matching risk-takers who need capital, with savers who are willing to earn a risk premium. Finance gets a bad rap for being a large part of the economy, and there are many headlines that enflame that view. I, myself, have a dim view of many financial practices. I have likened asset management to the vitamin industry — it sells noise as signal. But the story of finance broadly goes hand in hand with human progress. It might not be “God’s work” as Goldman’s boss once cringe-blurted, but its most extreme detractors as well as the legions of “I wish I was doing something more meaningful with my life” soldiers are discounting the value of its function which is buried in abstraction. Finance is code, so if software is eating the world, financialization is its dinner date.

Moontower #144

[I’m touching down in Maui this morning with my family for Spring Break. I won’t open the laptop this week so Moontower will be off next Sunday.]


Friends,

It’s been a crazy “Q1” as the suits say (seasonal references that favor fiscal orbits over solar ones still can’t escape the “time is a flat circle” vibe. A semantic loss all around, well-played all of us). In keeping with my Spring Break, I’ll re-post links to the more popular articles I wrote in the past few months in case any new or old readers want to catch up. There won’t be new content in the next 2 weeks.

Drawing Better Outcomes From Fat-Tailed Distributions

✍️There’s Gold In Them Thar Tails: Part 1 (13 min read)

✍️There’s Gold In Them Thar Tails: Part 2 (24 min read)

A meta-comment about the process of writing these. The thinking behind the posts was heavily inspired by Rohit Krishnan’s Spot The Outlier. When I first read his article, I knew it was deeply insightful but I struggled to fully grok it. I saved it in my task dashboard so I would re-visit it occasionally. By keeping it top of mind, I was more primed to “see” it in the wild. There was a back and forth between exposing myself to the post, following his references, and trying to reason about it in the context of what I already knew. This brings me to an encouraging point (I think). Understanding an idea you don’t get fully get is often just a matter of repetition broken up by rests and just enough space in your RAM to give your attention filter a chance to see it around you. It’s a mix of focused and diffuse thinking.

I imagine some readers are thinking “Kris, that post was not hard to understand…you’re supposed to be an options trader?!” I found it hard, what can I say. The journey to comprehend it (at least enough to write a few thousand words on it) is more encouraging than the distress of being dense in the first place. Which is a roundabout way of saying to understand something just keep trying from different angles. Give yourself rest. And trust in repeated exposure. I hope that advice helps next time you try to bang a concept into your skull. Fluid intelligence peaks in your 20s so knowing how to learn requires believing that you can. I’m 100% sure you can.

If you enjoyed this ensemble of concepts (finding outliers, Berkson’s Paradox, correlation breakdown in the extremes), I encourage you to read another treatment that adds to and reinforces the conversation:

✍️ Searching for outliers (22 min read)
by @benskuhn

The post is about better decision-making in fat-tailed distributions. Since they exist in many real-world matters, you should care. The end of the post has good recommendations while the beginning helps you differentiate between thin and fat-tailed distributions.

Some highlights:

  • As the dating example shows, most people have some intuition for this already, but even so, it’s easy to underrate this and not meet enough people. That’s because the difference between, say, a 90th and 99th-percentile relationship is relatively easy to observe: it only requires considering 100 candidates, many of whom you can immediately rule out. What’s harder to observe is the difference between the 99th and 99.9th, or 99.9th and 99.99th percentile, but these are likely to be equally large. Given the stakes involved, it’s probably a bad idea to stop at the 99th percentile of compatibility. This means that sampling from a heavy-tailed distribution can be extremely demotivating, because it requires doing the same thing, and watching it fail, over and over again: going on lots of bad dates, getting pitched by lots of low-quality startups, etc. An important thing to remember in this case is to trust the process and not take individual failures, or even large numbers of failures, as strong evidence that your overall process is bad.
  • Often, you’ll have a choice between spending time on optimizing one sample or drawing a second sample—for instance, editing a blog post you’ve already written vs. writing a second post, or polishing a message on a dating app vs. messaging a second person. Some amount of optimization is worth it, but in my experience, most people are way over-indexed on optimization and under-indexed on drawing more samples.
  • This is similar to how venture capitalists are often willing to invest in the best companies at absurd-seeming valuations. The logic goes that if the company is a “winner,” the most important thing is to have invested at all and the valuation won’t really matter. So it’s not worth it to the VC to try very hard to optimize the valuation at which they invest.

Finally, I can offer an example sitting right under everyone’s nose: choosing which books to read. In How to Read: Lots of Inputs and a Strong Filter, Morgan Housel writes:

The conflict between these two – most books don’t need to be read to the end, but some books can change your life – means you need two things to get a lot out of reading: Lots of inputs and a strong filter…A good reading filter is more art than science. You’ll have to find one that works for you. The bigger point is that the highest odds of finding the right piece of information comes from inundating yourself with information but very quickly being able to say, “that ain’t it.”

The Moloch Series

You cannot unsee the god of unhealthy competition.

✍️Don’t Look Up, It’s Moloch (10 min read)

Once you feel sufficiently Moloch-pilled you need the serum:

✍️Putting Moloch To Rest (7 min read)

To reinforce the cure (again, repetition folks) see this quirky and enjoyable post:

✍️ Slack (4 min read)
by Zvi Mowshowitz

Zvi’s writing has an almost poetic cadence and sticky phrasing. His blog is a minimalist rabbit hole. He’s in the Magic: The Gathering Hall of Fame and a former market maker so I’m probably biased towards his kind of geekery.

Self-improvement

✍️Lessons From Susquehanna (5 min read)

Todd Simkin’s interview re-hashed a collection of deeply influential ideas regarding learning and communication from my professional career

✍️Being A Pro And Permission To Be Serious (12 min read)

Discipline and earnestness feel quaint in the theater of memes modernity hyper-manufactures. Don’t fall for it.

Hedging

✍️From CAPM To Hedging (16 min read)

Ideas in this post:

  • Variance is a measure of dispersion for a single distribution. Covariance is a measure of dispersion for a joint distribution.
  • Just as we take the square root of variance to normalize it to something useful (standard deviation, or in a finance context — volatility), we normalize covariance into correlation.
  • Intuition for a positive(negative) correlation: if X is N standard deviations above its mean, Y is r * N standard deviations above(below) its mean.
  • Beta is r * the vol ratio of Y to X. In a finance context, it allows it allows us to convert a correlation from a standard deviation comparison to a simple elasticity. If beta = 1.5, then if X is up 2%, I expect Y to be up 3%
  • Correlation is symmetrical. Beta is not.
  • R2 is the variance explained by the independent variable. Risk remaining is the volatility that remains unexplained. It is equal to sqrt(1-R2).
  • There is a surprising amount of risk remaining even if correlations are strong. At a correlation of .86, there is 50% unexplained variance!
  • Don’t compute robotically. Reason > formulas.

✍️If You Make Money Every Day, You’re Not Maximizing (28 min read)

Part stories and part technical discussion of how to think about reducing risk.


Money Angle

Finance Guilt

I’ve said several times that finance is really just code. Like software, it’s an abstraction skin pulled over physical features. One can feel a bit disembodied if their formulation of the world for 8-12 hours a day are prices. Prices that collapse all of human enterprise, from the dirt under its fingernails to the sunrises and sunsets between now and some expiration date, into some Excel number format.

Just as software intermediates for less, financial innovation lowers the cost of go-betweens. In finance, the things went-between are people paying to offload risk to people looking to get paid for warehousing risk. In software and finance, skimming a tiny bit of rent on those transactions is lucrative.

How good or bad we can feel about the degree of skimming depends on how much surplus is created versus the higher friction model. The value of information liquidity is fairly obvious so Google enjoyed a positive reputation for at least its first decade in business. Meanwhile, finance feels like a constant barrage of “what did Wells Fargo do now?” or words that rhyme with Fonzi. People outside finance can be excused for having a dim, albeit biased, view of the profession since nobody reports on people doing an honest job.

With that in mind, I leave you with Mitchell’s understandable question:

Here’s my quick response:

Agustin’s response:

I’ll wrap with a footnote from a recent post:

The slicing and dicing of risk is finance’s salutary arrow of progress. Real economic growth is human progress in its battle against entropy. By farming, we can specialize. By pooling risk, we can underwrite giant human endeavors with the risk spread out tolerably. People might not sink the bulk of their net worth into a home if it wasn’t insurable. Financial innovation is matching a hedger with the most efficient holder of the risk. It’s matching risk-takers who need capital, with savers who are willing to earn a risk premium. Finance gets a bad rap for being a large part of the economy, and there are many headlines that enflame that view. I, myself, have a dim view of many financial practices. I have likened asset management to the vitamin industry — it sells noise as signal. But the story of finance broadly goes hand in hand with human progress. It might not be “God’s work” as Goldman’s boss once cringe-blurted, but its most extreme detractors as well as the legions of “I wish I was doing something more meaningful with my life” soldiers are discounting the value of its function which is buried in abstraction. Finance is code, so if software is eating the world, financialization is its dinner date.


Last Call

December 1984:

✍️The Day Los Angeles’ Bubble Burst (4 min read)

Now:

✍️Is the Housing Market Broken? (4 min read)
by Ben Carlson

See y’all in 2 weeks!

Mahalo

Moontower #143

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:

  1. We want to hedge the risks we are not paid to take.
  2. 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.

If You Make Money Every Day, You’re Not Maximizing

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, passed 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 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 the arbitrage relationships in calendar spreads you learn in basic training. During 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 taking 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. It illuminated approaches 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. WTI was on its way to $100/barrel for the first time, and I was seeing significant dislocations in the vol markets between oil and products1. 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. They always do. New competitors will show up 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 to get.

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 hardly meek or dumb. They simply had different risk tolerances because of how they were 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.

This post is a discussion of hedging and risk management.

Let’s begin.


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 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. A boring utility stock might trade 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 2.

If you have a differentiated opinion about a catalyst, the most efficient way to express it will be through 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! Go a step further. Suppose you have an even finer view — you can handicap the direction. Now 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 parlay bets. 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, and state policy. It also depends on some pretty specific events. For example, “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 mitigate3. 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:

  1. We want to hedge the risks we are not paid to take.
  2. 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 its 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

[As a pedological matter, I’m being a bit brusque. Bear with me. The principle and its demonstration are powerful, even if the details fork in practice.]

Let’s start with coin flips:

[A] You flip a coin 10 times, you expect 5 heads with a standard deviation of 1.584.

[B] You flip 100 coins you expect 50 heads with a standard deviation of 5.

Your expectancy scaled with N. 10x more flips, 10x more expected heads.

But your standard deviation (ie volatility) only grew by √10 or 3.16x.

The volatility or risk only scaled by a factor of √N while expectancy grew by N.

This is the basis of one of my most fundamental posts, Understanding Edge. Casinos and market-makers alike “took a simple idea and took it seriously”. Taking this seriously means recognizing that edges are incredibly valuable. If you find an edge, you want to make sure to get as many chances to harvest it as possible. This has 2 requirements:

  1. You need to be able to access it.
  2. You need to survive so you can show up to collect it.

The first requirement requires spotting an opportunity or class of opportunities, investing in its access, and warehousing the resultant risk. The second requirement is about managing the risk. That includes hedging and all its associated costs.

The paradox is less mystifying as the problem takes shape.

We need to take risk to make money, but we need to reduce risk to survive long enough to get to a large enough number of bets on a sliver of edge to accumulate meaningful profits. Hedging is a drawbridge from today until your capital can absorb more variance.

The Interaction of Trading Costs, Hedging, and Risk/Reward

Hedging reduces variance, in turn improving the risk/reward of a strategy. This comes at a substantial cost. Every options trader has lamented how large of line-item this cost has been over the years. Still, as the cost of survival, it is non-negotiable. We are going to hedge. So let’s pull apart the various interactions to gain intuition for the various trade-offs. Armed with the intuition, you can then fit the specifics of your own strategies into a risk management framework that aligns your objectives with the nature of your markets.

Let’s introduce a simple numerical demonstration to anchor the discussion. Hedging is a big topic subject to many details. Fortunately, we can gesture at a complex array of considerations with a toy model.

The Initial Proposition

Imagine a contract that has an expected value of $1.00 with a volatility (i.e. standard deviation) of $.80. You can buy this contract for $.96 yielding $.04 of theoretical edge.

Your bankroll is $100.

[A quick observation so more advanced readers don’t have this lingering as we proceed:

The demonstration is going to bet a fixed amount, even as the profits accumulate. At first glance, this might feel foreign. In investing we typically think of bet size as a fraction of bankroll. In fact, a setup like this lends itself to Kelly sizing5. However, in trading businesses, the risk budget is often set at the beginning of the year based on the capital available at that time. As profits pile up, contributing to available capital, risk limits and bet sizes may expand. But such changes are more discrete than continuous so if we imagine our demonstration is occurring within a single discrete interval, perhaps 6 months or 1 year, this is a reasonable approach. It also keeps this particular discussion a bit simpler without sacrificing intuition.]

The following table summarizes the metrics for various trial sizes.

What you should notice:

  • Expected value grows linearly with trial size
  • The standard deviation of p/l grows slower (√N)
  • Sharpe ratio (expectancy/standard deviation) is a measure of risk-reward. Its progression summarizes the first 2 bullets…as trials increase the risk/reward improves

Introducing Hedges

Let’s show the impact of adding a hedge to reduce risk. Let’s presume:

  • The hedge costs $.01.

    This represents 25% of your $.04 of edge per contract. Options traders and market makers like to transform all metrics into a per/contract basis. That $.01 could be made up of direct transaction costs and slippage.

    [In reality, there is a mix of drudgery, assumptions, and data analysis to get a firm handle on these normalizations. A word to the uninitiated, most of trading is not sexy stuff, but tons of little micro-decisions and iterations to create an accounting system that describes the economic reality of what is happening in the weeds. Drunkenmiller and Buffet’s splashy bets get the headlines, but the magic is in the mundane.]

  • The hedge cuts the volatility in half.

Right off the bat, you should expect the sharpe ratio to improve — you sacrificed 25% of your edge to cut 50% of the risk.

The revised table:

Notice:

  • Sharpe ratio is 50% higher across the board
  • You make less money.

Let’s do one more demonstration. The “more expensive hedge scenario”. Presume:

  • The hedge costs $.02

    This now eats up 50% of your edge.

  • The hedge reduces the volatility 50%, just as the cheaper hedge did.

Summary:

Notice:

  • The sharpe ratio is exactly the same as the initial strategy. Both your net edge and volatility dropped by 50%, affecting the numerator and denominator equally. 

  • Again the hedge cost scales linearly with edge, so you have the same risk-reward as the unhedged strategy you just make less money.

If hedging doesn’t improve the sharpe ratio because it’s too expensive, you have found a limit. Another way it could have been expensive is if the cost of the hedge stayed fixed at $.01 but the hedge only chopped 25% of the volatility. Again, your sharpe would be unchanged from the unhedged scenario but you just make less money.

We can summarize all the results in this chart.

The Bridge

As you book profits, your capital increases. This leaves you with at least these choices:

  1. Hedge less since your growing capital is absorbing the same risk
  2. Increase bet size
  3. Increase concurrent trials

I will address #1 here, and the remaining choices in the ensuing discussion.

Say you want to hedge less. This is always a temptation. As we’ve seen, you will make money faster if you avoid hedging costs. How do we think about the trade-off between the cost of hedging and risk/reward?

We can actually target a desired risk/reward and let the target dictate if we should hedge based on the expected trial size.

Sharpe ratio is a function of trial size:

where:

E = edge
σ = volatility
N = trials

If we target a sharpe ratio of 1.0 we can re-arrange the equation to solve for how large our trial size needs to be to achieve the target.

If our capital and preferences allow us to tolerate a sharpe of 1 and we believe we can get at least 400 trials, then we should not hedge.

Suppose we don’t expect 400 chances to do our core trade, but the hedge that costs $.01 is available. What is the minimum number of trades we can do if we can only tolerate a sharpe as low as 1?

Using the same math as above (1/.075)2 = 178

The summary table:

If our minimum risk tolerance is a 1.5 sharpe, we need more trials:

If your minimum risk tolerance is 1.5 sharpe, and you only expect to do 2 trades per business day or about 500 trades per year, then you should hedge. If you can do twice as many trades per day, it’s acceptable to not hedge.

These toy demonstrations show:

  • If you have positive expectancy, you should be trading
  • The cost of a hedge scales linearly with edge, but volatility does not
  • If the cost of a hedge is less than its proportional risk-reduction you have a choice whether to hedge or not
  • The higher your risk tolerance the less you should hedge
  • The decision to dial back the hedging depends on your risk tolerance (as proxied by a measure of risk/reward) vs your expected sample size

Variables We Haven’t Considered

The demonstrations were simple but provides a mental template to contextualize cost/benefit analysis of risk mitigation in your own strategies. We kept it basic by only focusing on 3 variables:

  • edge
  • volatility
  • risk tolerance as proxied by sharpe ratio

Let’s touch on additional variables that influence hedging decisions.

Bankroll 

If your bankroll or capital is substantial compared to your bet size (perhaps you are betting far below Kelly or half-Kelly prescribed sizes) then it does not make sense to hedge. Hedges are negative expectancy trades that reduce risk.

We can drive this home with a sports betting example from the current March Madness tournament:

If you placed a $10 bet on St. Peters, by getting to the Sweet 16 you have already made 100x. You could lock it in by hedging all or part of it by betting against them, but the bookie vig would eat a slice of the profit. More relevant, the $1000 of equity might be meaningless compared to your assets. There’s no reason to hedge, you can sweat the risk. But what if you had bet $100 on St. Pete’s? $10,000 might quicken the ole’ pulse. Or what if you somehow happened upon a sports edge (just humor me) and thought you could put that $10k to work somewhere else instead of banking on an epic Cinderella story? If St. Pete’s odds for the remainder of the tourney are fair, then you will sacrifice expectancy by hedging or closing the trade. If you are rich, you probably just let it ride and avoid any further transaction costs.

If you are trading relatively small, your problem is that you are not taking enough risk. The reason professionals don’t take more risk when they should is not because they are shy. It’s because of the next 2 variables.

Capacity Per Trade

Many lucrative edges are niche opportunities that are difficult to access for at least 2 reasons.

  • Adverse selection

    There might only be a small amount of liquidity at dislocated prices (this is a common oversight of backtests) because of competition for edge. 

    Let’s return to the contract from the toy example. Its fair value is $1.00. Now imagine that there are related securities that getting bid up and market for our toy contract is:

 bid  ask
.95 – 1.05

10 “up” (ie there are 10 contracts on the offer and 10 contracts bid for)

Based on what’s trading “away”, you think this contract is now worth $1.10.

Let’s game this out.

You quickly determine that the .95-1.05 market is simply a market-maker’s bid-ask spread. Market-makers tend to be large firms with tentacles in every related market to the ones they quote. It’s highly unlikely that the $1.05 offer is “real”. In other words, if you tried to lift it, you would only get a small amount of size.

What’s going on?

The market-maker might be leaving a stale quote to maximize expectancy. If a real sell order were to come in and offer at $1.00, the market maker might lift the size and book $.10 of edge to the updated theoretical value. 

Of course, there’s a chance they might get lifted on their $1.05 stale offer but they might honor only a couple contracts. This is a simple expectancy problem. If 500 lots come in offered at $1.00, and they lift it, they make $5,000 profit ($.10 x 500 x option multiplier of 100). If you lift the $1.05 offer and they sell you 10 contracts, they suffer a measly $50 loss. 

So if they believe there’s a 1% chance or greater of a 500 lot naively coming in and offering at mid-market then they are correct in posting the stale quote.

What do you do?

You were smart enough to recognize the game being played. You used second-order thinking to realize the quote was purposefully stale. In a sense, you are now in cahoots with the market maker. You are both waiting for the berry to drop. The problem is your electronic “eye” will be slower than the market-maker to snipe the berry when it comes in. Still, even if you have a 10% chance of winning the race, it still makes sense to leave the quote stale, rather than turn the offer. If you do manage to get at least a partial fill on the snipe, there’s no reason to hedge. You made plenty of edge, traded relatively small size, and most importantly know your counterparty was not informed!

As a rule, liquidity is poor when trades are juiciest. The adverse selection of your fills is most common in fast-moving markets if you do not have a broad, fast view of the flows. This is why a trader’s first questions are “Do I think I’m the first to have seen this order? Did someone with a better perch to see all the flow already pass on this trade?”

In many markets, if you are not the first you might as well be last. You are being arbed because there’s a better relative trade somewhere out there that you are not seeing.

[Side note: many people think a bookie or market-maker’s job is to balance flow. That can be true for deeply liquid instruments. But for many securities out there, one side of the market is dumb and one side is real. Markets are often leaned. Tables are set when certain flows are anticipated. If a giant periodic buy order gets filled at mid-market or even near the bid, look at the history of the quote for the preceding days. Market-making is not an exercise in posting “correct” markets. It’s a for-profit enterprise.]

  • Liquidity

    The bigger you attempt to trade at edgy prices, the more information you leak into the market. You are outsizing the available liquidity by allowing competitors to reverse engineer your thinking. If a large trade happens and immediately looks profitable to bystanders, they will study the signature of how you executed it. The market learns and copies. The edge decays until you’re flipping million dollar coins for even money as a loss leader to get a look at juicier flow from brokers. 

    As edge in particular trades dwindles, the need to hedge increases. The hedges themselves can get crowded or at least turn into a race.

Leverage

If a hedge, net of costs, improves the risk/reward of your position, you may entertain the use of leverage. This is especially tempting for high sharpes trades that have low absolute rates of return or edge. Market-making firms embody this approach. As registered broker-dealers they are afforded gracious leverage. Their businesses are ultimately capacity constrained and the edges are small but numerous. The leverage combined with sophisticated diversification (hedging!) creates a suitable if not impressive return on capital.

The danger with leverage is that it increases sensitivity to path and “risk of ruin”. In our toy model, we assumed a Gaussian distribution. Risk of ruin can be hard to estimate when distributions have unknowable amounts of skew or fatness in their tails. Leverage erodes your margin of error.

General Hedging Discussion

As long as hedging, again net of costs, improves your risk/reward there is substantial room for creative implementation. We can touch on a few practical examples.

Point of sale hedging vs hedging bands

In the course of market-making, the primary risk is adverse selection. Am I being picked off? If you suspect the counterparty is “delta smart” (whenever they buy calls the stock immediately rips higher), you want to hedge immediately. This is a race condition with any other market makers who might have sold the calls and the bots that react to the calls being printed on the exchange. That is known as a point-of-sale hedge is an immediate response to a suspected “wired” order.

If you instead sold calls to a random, uninformed buyer you will likely not hedge. Instead, the delta risk gets thrown on the pile of deltas (ie directional stock exposures) the firm has accumulated. Perhaps it offsets existing delta risk or adds to it. Either way, there is no urgency to hedge that particular deal.

In practice, firms use hedging bands to manage directional risk. In a similar process to our toy demonstration, market-makers decide how much directional risk they are willing to carry as a function of capital and volatility. This allows them to hedge less, incurring less costs along the way, and allowing their capital to absorb randomness. Just like the rich bettor, who lets the St. Peter’s bet ride.

In The Risk-Reversal Premium, Euan Sinclair alludes to band-based hedging:

While this example shows the clear existence of a premium in the delta-hedged risk-reversal, this implementation is far from what traders would do in practice (Sinclair, 2013). Common industry practice is to let the delta of a position fluctuate within a certain band and only re-hedge when those bands are crossed. In our case, whenever the net delta of the options either drops below 20 or above 40, the portfolio is rebalanced by closing the position and re-establishing with the options that are now closest to 15-delta in the same expiration.

Part art, part science

Hedging is a minefield of regret. It’s costly, but the wisdom of offloading risks you are not paid for and conforming to a pre-determined risk profile is a time-tested idea. Here’s a dump of concerns that come to mind:

  • If you hedge long gamma, but let short gamma ride you are letting losers grow and cutting winners short. Be consistent. If your delta tolerance is X and you hedge twice a day, you can cut all deltas in excess of X at the same 2 times every day. This will remove discretion from the decision. (I had one friend who used to hedge to flat every time he went to the bathroom. As long as he was regular this seemed reasonable to me.)

  • Low net/high gross exposures are a sign of a hedged book. There are significant correlation risks under that hood. It’s not necessarily a red flag, but when paired with leverage, this should make you nervous. 

  • Are you hedging your daily, weekly, or monthly p/l? Measures of local risk like Greeks and spot/vol correlation are less trustworthy for longer timeframes. Spot/vol correlation (ie vol beta) is not invariant to price level, move size, and move speed. Longer time frames provide larger windows for these variables to change.  If oil vol beta is -1 (ie if oil rallies 1%, ATM vol vols 1%) do I really believe that the price going from 50 to 100 cuts the vol in half?

  • There are massive benefits to scale for large traders who hedge. The more flow they interact with the more opportunity to favor anti-correlated or offsetting deltas because it saves them slippage on both sides. They turn everything they trade into a pooled delta or several pools of delta (so any tech name will be re-computed as an NDX exposure, while small-caps will be grouped as Russell exposures). This is efficient because they can accept the noise within the baskets and simply hedge each of the net SPX, NDX, IWM to flat once they reach specified thresholds.

    The second-order effect of this is subtle and recursively makes markets more efficient. The best trading firms have the scale to bid closest to the clearing price for diversifiable risk6. This in turn, allows them to grab even more market share widening their advantage over the competition. If this sounds like big tech7, you are connecting the dots. 

Wrapping Up

The other market-makers in the product options pit were not wrong to hedge or close their trades as quickly as they did. They just had different constraints. Since they were trading their own capital, they tightly managed the p/l variance.

At the same time, if you were well-capitalized and recognized the amount of edge raining down in the market at the time, the ideal play was to take down as much risk as you could and find a hedge with perhaps more basis risk (and therefore less cost because the more highly correlated hedges were bid for) or simply allow the firm’s balance sheet to absorb it.

Since I was being paid as a function of my own p/l there was not perfect alignment of incentives between me and my employer (who would have been perfectly fine with me not hedging). If I made a great bet and lost, it would have been the right play but I personally didn’t want to tolerate not getting paid.

Hedging is a cost. You need to weigh that with the benefit and that artful equation is a function of:

  • risk tolerance at every level of stakeholder — trader, manager, investor
  • capital
  • edge
  • volatility
  • liquidity
  • adverse selection

Maximizing is uncomfortable. Almost unnatural. It calls for you to tolerate larger swings, but it allows the theoretical edge to pile up faster. This post offers guardrails for dissecting a highly creative problem.

But if you consistently make money, ask yourself how much you might be leaving on the table. If you are making great trades somewhere, are you locking it in with bad trades? If you can’t tell what the good side is that’s ok.

But if you know the story of your edge, there’s a good chance you can do better.