Moontower #232

Comments

Top
Latest
Discussions

Moontower #154
Ambition As An Anxiety disorder
 •

KRIS ABDELMESSIH
2
GME trade
Looking to do this tomorrow

 •

KRIS ABDELMESSIH
7
Moontower #148
3-Card Macro
 •

KRIS ABDELMESSIH
5
Lessons From Ed Thorp’s Interview With Tim Ferriss
Moontower Munchies #50
 •

KRIS ABDELMESSIH
1
Using Options Better
including practical tips

 •

KRIS ABDELMESSIH
4
“Achievement” is a fickle mistress
Friends, A theme running through recent posts has been about preparing for post HS life, or really helping your kids think about the future. The…

 •

KRIS ABDELMESSIH
3
Nah…you just ain’t seein’ the ball
When you hear “But the market doesn’t care about fundamentals” 😭

 •

KRIS ABDELMESSIH
Moontower #170
The Investing Version Of “Nothing Good Happens After Midnight”
 •

KRIS ABDELMESSIH
2
Born On Third
Moontower #200
 •

KRIS ABDELMESSIH
12
Weighting An Options Pair Trade
A question from the mailbag

 •

KRIS ABDELMESSIH
7
© 2024 Kris Abdelmessih
Privacy ∙ Terms ∙ Collection notice
Start WritingGet the app
Substack is the home for great culture

When it’s normal to have no idea what your returns are

The lingua franca of asset management regardless of strategy is returns. But this is not necessarily true in trading. In my own 21 years of trading, it was never even brought up internally. It gets mentioned somewhere far in the background. In vague terms at best. And even then, the context is more of a hurdle than a target.

We’re going to talk about this in 2 parts.

Today

I’ll walk through what this meant in the 3 phases of my career (with plenty of color interspersed):

  1. Being a market maker at SIG
  2. Running my own market-making group financed by a Chicago firm that backs traders
  3. As portfolio manager within a relative value volatility trading hedge fund. This last job was for an entity that was backed by LP money and therefore beholden to the concept, language, and delivery of returns. And yet, the idea of returns was alien to how I ran my business there.

Next week

I’ll connect this back to a reader question that got me thinking about all this in the first place:

How important is (il)liquidity in options when making risk-defined trades such as credit/debit spreads or buying single call/put options?

Hmm.

I can feel the doubt.

“Bruh, those lily pads are in different ponds, how we makin this leap?”

We gonna make it. Off we go…

At SIG

My first trading job for SIG where I had my own account and P/L was an equity options market maker on the AMEX floor.

The AMEX, like the NYSE, is a specialist system. There are “posts” where the options on a list of tickers trade. The specialist is like a lead market-maker who sees the full order book and is required to make a market according to a set of rules and guidelines. The specialist designation is a bundle of obligations and privileges. They must maintain an “orderly” market, set the vol curves which then disseminate electronic bids and offers for every strike and maturity for a name to the world. They are also entitled to 40% of the volume that trades on the bid or at the ask.

Market makers stand in front of the specialist post and announce any bids or offers that improve the specialists’ market. The market-makers are allowed to participate alongside the specialist on the bids and offers if they agree that they are “on the market”. My first year trading, I was a market-maker. The major names at my post were AIG, Qwest, Eastman Kodak, Corning, Cheesecake Factory, and about 25 other stocks. One that was notably missing because it was just delisted from that post — Enron.

As a novice trader, it was really about strapping on a helmet and getting experience. I wasn’t going to be taking massive risks but in the course of trading if I saw anything noteworthy I could discuss it with my manager to see if I should be. There were 3 notable things that happened in my time there.

  1. AIG accounting scandal (this was the only time I ever talked to Jeff Yass about a trade. UBS put up a giant print in the options and Jeff dm’d me to call him with details on one of the black phones placed near the trading posts. I was scared shitless to call because I didn’t do any part of the trade and was afraid he was going to undress me for missing it. He just listened, thanked me, and hung up. I never heard another word about it).
  2. Massive buyers of Qwest teeny puts by cap structure arb flow who were trading puts vs CDS. Selling them week after week in size and overhedging the hell out of them made my year. It was also stressful because up days were painful, but the stock leaked lower and the puts barely budged.

    [A year or two a colleague ran the same playbook in Xerox in much larger size and had an amazing year. If I remember correctly, that fellow was banned from Vegas casinos for card-counting by the time he was 22. He left SIG after that year, 25 or 26 years old, co-founded a prop firm and retired very wealthy in his 30s. Our wily friend also made the news for a buying a call option on a penthouse from its owner that ended up being the highest value residential RE trade in the city where it happened. Not a small city. One funny thing I remember about people’s impression of him — he was very lazy but insanely smart. And despite my personal belief that endurance and effort > brains, there were a lot of counterexamples to this back in those days. There were savants who struck it rich and peeled off. The billionaires in the options world were the savants who worked their asses off to build businesses, but the clever cats won life. You got $50mm in 2009 and your like 33 years old. You’re gonna triple it by age 50. In flip-flops with a flip phone.]

  3. I found a dividend in Kodak that was being priced in the wrong month. Which brings you to the question — how do you pick off the people who stand next to you all day with a structure that doesn’t tip them off too quickly and also disguises that it’s you?

    [This is a separate topic but trading cultures revere cleverness. It’s a game where the goal is to take people’s money. Any harmony is just a long-run game theoretic compromise. It is fundamentally adversarial. Can you see why effective altruism starts to look like effective autism when you consider the frames traders must adopt to deal with the discomfort of their decisions? At least back then the sociopaths were more forthcoming in their intentions rather than torturing normal people with trolley problems.]

After a year at that post, I was moved to one that included Microsoft (I was there when they announced their first dividend — it was special $3 div I believe), Oracle, and Expedia. That was 2003. After 2017, 2003 was my second least favorite year. There was less action compared to prior years and markets were getting tighter (the purely electronic ISE grabbed a ton of market share). I felt deeply discouraged. I came into the business near a peak and this was my first downcycle. I extrapolated doom.

So what were my returns in those first 2 years?

I have no idea. I had a close to $1mm profits in the first year and broke even in the second year.

I don’t know how much capital I used. In fact, they wouldn’t want me to know. For example, the margin I was paying financing charges on is likely much higher than it what it was in reality considering the difference in rates a small trader gets versus a giant client like SIG. It would only make sense for the partners to effectively lend me the difference rather than allowing me the credit for funding at the firm’s rates. It’s 6 in one hand, half dozen in the other when you zoom out but it does obscure your true rate of return. It wasn’t clear how much margin you are using or how much it varied. And they had no incentive to elucidate this.

If you were looking to leave then I’m sure you could have backed into a good guess for how much capital you needed. Which is critical if you are looking to build one of these businesses since of course it’s still a capital allocation decision whose ROI must be compared to other uses for the cash. But when you are making the donuts, there’s no talk of return.

So how do you talk about the business?

It’s raw dollars. Management figures “Ok, the average MSFT market maker for SIG should trade 5,000 lots a day for a penny of edge (remember the multiplier is 100, so it’s a true $1 per lot) times 252 trading days — the spot is worth $1.25mm per year”.

[If you make less, they’ll ding you in your bonus, if you make more, they say the trading was better that year so you were expected to make more — here’s your expected bonus. If you get discretionary bonuses you know the routine. You’ll get a verbal reach around in your bonus meeting, but then the number falls short of the rhetoric. I’ve been able to laugh about this for a long time now, but my wife can remember the days where my traders friends and I would plan what we would yell as we “flipped the desk over” 3 months in advance of our disappointing meetings. No matter how much you get paid, it’s always a letdown. She would joke about the Trader Wives Club where they’d have to hear us whine for 3 months before our reviews, and another week afterwards.]

In short, a trading spot occupied by a someone who knows what they’re doing has an expected p/l with a distribution. Based on the activity in the names that year, the value of the spot could be upgraded or downgraded for the following year. There’s always a dollar target and and the outcome is a debate about how much skill the trader brought to the result versus how the assumptions of volume, volatility, and competitive forces varied from the start-of-year forecast.

If the cost to man the spot makes sense compared to the expected p/l, someone will be assigned to it. Spots that are more valuable will be staffed with the more experienced/talented traders (ie you should expect that meme stocks are piloted by a prop firms’ top traders). So while there’s no concept of return, hurdles and opportunity costs are baked into the staffing decisions.

Backed by Prime

From 2008 until early 2012 I was backed by Prime International, a prop firm based in Chicago. Back then, they bankrolled about 100 traders, many in futures but there was several option pods of various sizes. I ran a mid-sized one and shared an office with their largest one (that pod was the largest market-maker in crude oil options in the late aughts).

These years were the most fun and learning I had in my career, outside the first year out of college as a trainee which was a zero-to-one combustion. I’ll save the stories for a non-print medium. I vaguely remember colleagues researching what it would take to create a small ice rink and get a penguin for the office. The fact that I would have put a 25 delta on it actually happening is a pretty good indication that this was not a normal work environment. Any job after this was gonna be a letdown but the floors’ days were numbered.

With the backer, everything was transparent. I was getting 70% of my p/l. I could see my daily margin. My shared and non-shared expenses. I could hire and fire as I wanted.

Yet again, no concept of return.

If you just looked at margin, you could back into an expectation that you should return 50-300% per year to make the gig worthwhile.

[This was in fact typical but I don’t think any pod back then was using more than $10mm and most utilizing less than $2mm. Floor trading isn’t that scalable. Ironically, the way to keep a floor well-fed is for fiduciaries to trade as if markets are more scalable than they actually are.]

Unfortunately margin isn’t a great denominator for returns. Buy a bunch of teeny options and you can mask risk. You could hunt for the cheapest thing to buy that makes a concern, defined too objectively on the back of assumptions, go away if you know what canned scenarios the risk group runs. I’m not saying this is done on a conscious or nefarious level but it’s too easy to affect the Ouija board by having a little extra preference for this strike or that maturity.

Computing return on average margin can also be weak depending on the nature of a strategy. Margin calculations are coarse proxies for risk. They aren’t custom enough for option traders. At one end they can be gamed, and on the other end they can be too conservative for arbitrage strategies (for example, no margin relief for WTI look-alike swaps if one leg is on ICE and the other on CME).

A picture is emerging. Return is difficult to compute because the denominator is murky.

We are accustomed to returns and volatilities. They let us use Sharpe ratios to measure risk-adjusted performance. But if we don’t have returns how do we get to risk limits that make sense? How do decide where to put capital?

Hedge fund days

In 2012, I moved to SF to build the commodity relative value volatility business for Parallax. It is a master fund with a host of sub strategies. LPs see returns but internally there’s no concept of returns at the strategy level. It’s just p/l that rolls up to the fund level. To be clear, this is typical for such a structure. It’s flexible.

The fund posts margin and manages risk such that the margin to equity ratio stays comfortably under 100% even in stressed conditions. Which means there’s always a cash buffer which can be held in T-bills, box spreads, or managed in any highly liquid way.

The sub-strategies margin requirements will bounce around based on the volatility and opportunities in the markets. Just to make up numbers, imagine the firm aum is $1B and runs 50% margin-to-equity. So in typical conditions, the margin requirement is $500mm.

Now consider that my margin requirement in the commodity book ranges between $20mm and $100mm depending on how much risk I’m taking. If I was a standalone fund and to be highly confident that my margin-to-equity wouldn’t exceed 80% than I’d need to raise $125mm. Most of the time I need much less, which causes a drag on returns but in the master fund structure I don’t really worry about this. The firm’s excess cash isn’t allocated to strategy as a hard constraint. The GP acts as the ultimate capital allocator internally.

So the best guess of what my returns are depend on the flawed denominator of average margin and relative to that number, they will always be worse if I’m a stand-alone fund because I need to raise far more capital than I’d typically be deploying.

How did it the business work in practice?

You’d come up with an annual expected p/l. In my case, the median was about 70% of the expectancy because I ran a positively skewed book.

[I was typically long vol convexity and often long gamma. When I was at Prime with my own money on the line, it was not uncommon to be paying 4 figure theta bills. I stood next to a guy that traded 100% of his own money that had a seven figure bill a few times a year. (Random thought but learned a lot about playing the player not the cards from him but this was a small market which he would turn into a game of heads-up no limit with the big customer. He recognized he had a lot of edge, and pushed. I hope he shifted gears when that was no longer the way you could play.)

In my fund book, you could buy a Porsche or Lambo every day with with the theta. That said — I kept a close eye on a very simple measure — don’t be long too much extrinsic premium unless there was a specific reason.

VRP language is something that feels like it comes from the asset management world not the floor trader world. There are exceptions. I knew some large short vol traders at every stop. The biggest lesson is that this game is far more artful than risk premia discourse pretends.

As for my own long vol bias and performance — this was not some trick of “Oh I lost half my years but won more in good years”. No backer, prop firm, or absolute return fund would tolerate that. I broke even or was down small 3 out of 20 years, made medium amounts most years and put up the numbers that drive the mean from the median around the GFC and the 3 year period spanning from the 2018 Volmageddon (although I wasn’t directly involved in that trade, it was the return of vol after the 2017 idiocy) through 2020. Look, the job pays when people are in pain. I don’t know what to tell you. The rest of the time I watch beta-maxxers and PE suits buy mansions. I write to feel prosocial. I don’t need trading to that feel that way. Sensing a dumb counterparty squirm, one who almost certainly was getting paid too much previously for charlatanism, is a reassuring hug from the god of markets as far as I’m concerned.

I am an agreeable human (I’m like 95th percentile on the Big Five personality test for this) but a highly disagreeable trader. Process, patience, fold, more patience, then f you sold. Boring, boring, boring, paper cuts, I hate this job, boring — violence. Put your style into simple words one day. It helps steer you back to the North Star whose light whose light you’ll most when your every decision feels like it takes you further into the dark.]

Back to the returns stuff. You peg an annual p/l target. Management implicitly considers how much risk needs to be tolerated to achieve that raw p/l, deems it satisfactory and off you go. Next year, the landscape is reviewed, growth initiatives weighed and you repeat a somewhat informal process. Any course-correction is mostly handled ad-hoc as the PM sees whether or not the environment calls for taking more or less risk. You can tell when there’s too many predators (entities who see the world in a similar way to us) vs prey (customers that have hedging or punting desires). There’s a time to hunt and time to hibernate. I say it all the time — this is a biological system not a Newtonian one.

So back to returns…it’s not quite right to think of return on margin. If you want to force a business like this into that framework you should probably just be conservative and consider how much AUM you’d need to run the strategy as a stand-alone fund. I’ll use a broad informed stroke. With a few hundred million in capital, I’d guess a strong manager with a trader mindset (as opposed to asset-manager mindset — if you’re in this business you know the difference so don’t @ me) could put up mean returns in the ballpark of 9-12% with the median between 50 and 70% of that.

[You can also see why many of these business are best housed within a fund that can flexibly allocate unutilized cash. The traders can be paid well enough to not tempt themselves into the brain damage of starting a fund of their own. To go out on your own has to be about more than money. There needs to a psychic reason to want your name on the door to endure what it takes to launch a fund.]

This is a damn good proposition because it behaves like long option position that you get paid to own. It’s unsurprising that the fees for the handful of managers who can do this (if you can even access them) are high. The proposition gets much worse if you’re taxable because it’s a short-term gain bonanza but of course many institutional allocators are tax-exempt.

Most of the risk lies in the ability for talented group of people to self-perpetuate themselves and the ability to assess that from the outside is probably almost zero. So all the usual caveats of active management apply.

Like I said earlier, next week I’ll tie this back to a seemingly unrelated question:

How important is (il)liquidity in options when making risk-defined trades such as credit/debit spreads or buying single call/put options?

Riffing on Paywalls, Trading & Options

Gather round. Let’s just chop it up in no particular order.

On Monday, I fired off an impromptu email with a trade I was doing. Disclaiming of course that it’s not a recommendation. I have no licenses and I’m not qualified to give financial advice. Buyer beware and all that. I sent it to paid subs only.

Actually, let me clarify the paywall. Last year I added some paid tiers on Substack. It was like $150/yr. There was also a $500 annual OG tier. For $150, it was just a chance to support the letter and OGs had that satisfaction plus a Zoom or IRL chat if they wanted. In other words, there was no extra content for paying. It was just a tip jar. I support other writers even if the content is free so I understand the impulse. Who am I to deny givers. So put the tiers in.

I have a friend in my book club who is a marketing ninja (people throw such superlatives around but this mf’er charges really high rates for good reason). He offered to “look at what I’m doing on the internet” pro bono. He saw how many people were supporting Moontower at the regular and especially OG level and remarked it was quite unusual for those percentages considering they weren’t getting any extra content. Paraphrasing: “Kris, people want to pay you. You just don’t give them an excuse. For many people it’s hard to pay for something even if they want to because the official price is zero. It’s a psychology thing.” Reminded me a bit of the “penny problem”.

I explained to him that I actually felt guilty or a sense of reciprocity for not delivering anything extra. But I feel strongly about giving away a lot for free. Charging also felt off.

Taking a longer, realistic view — time is time, and I give this letter a lot of time. I’m not some alien for whom this comes easy for. So the eggshell that idealism always rests in has cracks in the form of opportunity cost. The compromise to satisfy both my guilt and test his thesis that more people wanted to pay was to paywall a small fraction of my writing.

Anyway, that’s the genesis of the paywall. I’m happy with the mix. I feel better about all the guilts — opportunity cost of time, giving extra to payers, and not withholding what I hope is value for people who won’t or can’t pay.

The paywall also seemed like the right venue for sharing a trade I was doing. It’s a bit safer space since I don’t think anyone pays to hate-follow.

I’ll add— if you converted to paying because you think I discuss trades all-the-time you’ll be disappointed. I suspect I might do it more especially as my personal trading infra gets better with moontower.ai but I’d rather underpromise on the writing and let this place be a source of pleasant surprise instead of having it start from a transactional place where I feel the invisible pressure of coming up with stuff for the sake of delivering something that sounds useful. If I tell you I like something it’s because I do it. And it might be dumb. But that’s why it’s never a recommendation. You can only count on me translating what the turd-throwing monkey in my brain says back to you. You decide if that’s worth paying for, either way I’m publishing plenty of free stuff and some not free.

Moving on.

I did in fact do a trade. If you follow me on Twitter, I’m transparent and I even shared screenshots. I’m more Whimpering Puppy than Roaring Kitty but my real-time thought narration is less cryptic than memes. SO, I have that going for me.

I bought the GME June 20/30 call spread unhedged. I only bought 20. My intention was to buy 100. I was comfortable risking about $25k. I got filled at $2.08 giving me almost 4-1 if the stock expires $30 or higher. Unfortunately I left a bunch of dead soldiers (unfilled orders) behind and the stock got up to $30 the same day. $4k turned into $8k and I’m just mad. As Agustin Lebron preaches in Laws of Trading — “you are never happy with the size you trade”. It’s always too much too little in hindsight.

Although I didn’t share the trade idea in the free substack, I did share lots of thoughts publicly:

Messing around a bit. Used an option calculator and ran 300% flat vol sheets vs skewed vol sheets that roughly fit the market just to see how different the distributions are (stock ref $25 in $GME)

Which was a follow-up to:

Flat vol is what old people would call flat sheets. As if you ran the same vol on every strike. My gut market on this call spread if I’m allowed to be wide would have been $7.75-$8.75 knowing it was volatile squeeze stock with 2 weeks to expiry.

[This isn’t actually a short squeeze but it’s the only mental model I can match it to]

Looking at the table, my $7.75 bid would simply get tattoo’d. Anyway, hoping tomorrow the setup invites a little gamble. If we get more of the same flow as today, I’ll get the chance.

Back to the butterflies:

Fly density is just butterfly centered on the middle strike divided by the strike width. This is why vertical spreads are model free bets on the distribution. A lot of call skew or vol pushes the modal outcome to the left.

High call skew makes call spreads cheaper which implies lower probabilities of the stock going up. Which is why my original tweet is looking at how cheap the call spreads are and the market implying the stock lower.

Here’s one more this time including what a regular 30% stock distribution looks like to the picture (again using flat vols):

Image

You are getting unusually high odds to bet the stock is not going down by June expiration.

This is the same idea I’ve pointed out in winter gas or H/J nat gas CSO’s. When call skew is nuclear or stocks short squeeze for options market bidding for upside actually implies the stock is probably going to drop (which is consensus in a squeeze…it’s just a matter of when and how fast).

The down moves are stabilizing. Think of the up move as potential energy of a stretched rubber band. No matter how far you pull it the expected snap back point is the same. In fact, the bigger the squeeze the more likely the capitulation happens because the last short says uncle and represents the last buyer. There’s nobody left to buy.

This is why when when assets squeeze the put spreads get expensive. Consensus is down not up. Up is destabilizing, higher vol territory. Remember how you want to own the options AWAY from where it expires.

This is a classic demonstration. The market wants the options in the direction of the skew. It wants the “it probably won’t get there but if it does things are gonna break, yee haw!” It doesn’t want the options of where the stock will land. Or inverting, where the options are cheap (the cheapest body of a fly, therefore the most expensive butterfly) is where the stock is implied to land.

This account had good questions. I gave my best answers.

One account rebutted that options don’t just sit overnight with positive EV sitting in them.

Hey, I mostly agree. But this is a coin flip I believe the odds compensate for. Nobody knows where it’s landing. If RK rolls or changes his position the odds change…the most egregious dislocations in the surface probably fair up and something else breaks. In the tree of possibilities, the trade can work simply by the turn card coming out (ie new information in the form of flow that shuffles the deck in a new way). I don’t need to take this into expiry. I think there’s edge in the levels.

Here’s the thing — nobody has some quant model that knows where this thing is landing. This is a pure trading situation. Of course, I can be wrong. Hell, I told my wife I’d guess I have a 50% chance of incinerating the premium which is much higher than what flat sheets or a lower vol name would suggest.

But I have several ways to win. If go to the grave with these, I do think I’m getting odds because the market had to absorb this flow by moving the spread. It can’t diversify it away. Another way to win or at least manage the position comes from trusting my judgement on how to think about the matrix. You do this long enough, you chunk an options board the way a chess player chunks familiar patterns. “Hmm, that fly looks too cheap compared to that one…ahh when I try to execute I find out it’s not really there”.

As trading goes, this is not the hard part. What’s hard is when things are grinding tick by tick. That’s a miserable nerd market that burns my eyes. I don’t have opinions on stuff where everyone can think all day and night about what something is worth. In fact I don’t have opinions often. Right back to the “options don’t just have positive EV sitting in them”.

I do think you can make better decisions in the options landscape but that not the same bar as being a pure alpha option trader. That last bar is really high. The market likes to give you false directions to that party. It’s important to know what circumstances your heuristics are more likely to apply. Trading requires the tacit knowledge of when to switch gears between “I need to act without full info but right now I can act with even less info because the amount of info anyone has is not as high as it usually is”.

One last bit.

The reason I even looked at GME closely was serendipity. A friend had an angle on GME he wanted to bounce off me. It was a pet idea. Kind of weird but also something I thought similarly about in the psychology (which I don’t think is a view most people managing money would come to). It’s not a 4D chess thing either which is something I’m generally skeptical of anyway.

But chatting yesterday, he made an off-hand comment that highlighted why options are so interesting.

He texted:

all the probabilities are skewed to make people get long lol

This is exactly, what the cheap call spreads do. Which is why we say “they imply the stock much lower”. Again look at those fly distribution pics. You only make that statement if you understand options. But here’s the rub…what is the counterforce? What’s the thing that makes people want to get short not long?

The stock price itself.

It says get short. If you have an investor’s horizon you think, why is anyone paying $9B for a couple billions worth of T-bills*? Meanwhile, the options offer odds to get long.

[*On Wednesday it came out that the at-the-money share offering raised $2B….hmm and all it took was a few days of the stock trading in the 20s to absorb it…sounds bullish to me.]

The question of fundamental value has zero relevance to the now. It’s like using a yardstick to take the temperature. Don’t mix up the dashboards you use for long-term ideas for the gauges you use to consider the short-term.

And finally, we couldn’t resist…

while we are about to double our ETF coverage on moontower.ai we just had to add GME.

Image

Seriously, I’m stoked about how moontower.ai is coming along.

(If you use options, you should check it out. If you are just curious you can still sign up for free for the educational materials and MoontowerGPT)

A collateral benefit of the moontower.ai work is personally getting to spend more time in Jupyter notebooks as I sandbox ideas that are coming down the pipe. Coding is not a personal strength, I rely on Copilot A LOT. I only recently started using Git. But getting to build, learn, write, code, and bring together analytics in a way that leads to better decisions, practical actions, and teach is a super satisfying way to spend time. [By the way, nothing I code goes into production, that would be malpractice.]

These opportunities wouldn’t have come together if you didn’t give me a little hamster wheel in your brain to run on. I know if I do a good job on all fronts that elusive sweet spot of “sustainable because it’s valuable” and satisfying is possible.

So thank you.

Stay Groovy

Moontower #231

Friends,

A fantastic excerpt from the Founder’s episode on The Essays of Warren Buffet:

Buffet:

Some part of your business philosophy is not going to be financial and that’s the way it should be

A determination to have and to hold involves a mixture of personal and financial considerations. To some, our stand might seem highly eccentric. Charlie and I have long followed David Ogilvy’s advice, develop your eccentricities while you’re young. That way, when you get old, people won’t think that you’re gaga.

Certainly, our posture must seem odd to many in that arena, both companies and stocks are seen only as raw material for trades. Our attitude, however, fits our personalities and the way we want to live our lives. Winston Churchill once said, “You shape your houses and then they shape you”. We know the manner in which we wish to be shaped.

[With respect to arbitrage and paying attention to the active market…Buffet is not interested in that.]

“This is not how Charlie nor I wish to spend our lives. What is the sense in getting rich just to stare at a ticker tape all day? (If you don’t like staring at a ticker tape all day. Some people probably like doing that of course)

Founder’s host David Senra adds:

Figure out how you want to spend your life; and two, find out how to get rich doing that.

It’s usually not what you do, it’s how you do it. Look at almost any profession — you have realtors that make no money, and you have realtors that make millions. You have podcasters that make no money, you have podcasters that make millions. You have investors that don’t make any money and investors that make a ton. It’s not what you do, it’s how you do it. So to me, it’s like, no, let’s figure how to do both.

Let’s figure out, how do I want to spend my life? (that’s actually the hard question) and then from there, once you’re focused on that, how can I get rich at doing that?

 

I thought those bits went well with the softer themes I’ve been writing about this year regarding how to think about what to do, how to express your talents, and generally paddle in the same direction as your abilities.

And if you’re in the thick of it, this post holds a truth we can easily forget when hit a dip:

Easy to Expect. Hard to Predict (7 min read)
Scantron

The David Guetta story in here is a great demonstration of the post’s premise — life rewards repetition.

Money Angle

I’ve written about TIPs a few times:

This past month, Victor Haghani penned a post that clears up common misunderstandings. I’ve addressed several of them in my posts but I think he does a better job in a few spots, especially considering how short the post is. One thing that confirms what I already was doing — don’t hold them in a taxable account.

The title is also perfect because it strikes to the heart of the most common misunderstanding.

TIPS Do Offer Valuable Inflation Protection – But You Need to Decide What You’re Protecting (5 min read)

Money Angle For Masochists

Options twitter came alive this week since GME gapped higher on Monday after Roaring Kitty revealed on Sunday night that he owned 12mm shares of GME via options plus an additional 5mm shares.

I used some print data to reconstruct the implied vols he paid (source here).

IVs by moontower; print data via Unsusual Whales

chart by moontower

On Thursday the calls were $40 ITM…then GME announced a 75mm share offering causing the stock to gap down on Friday’s open before settling in around $9 ITM. His average price on the calls was about $5.55, paying on average 208% vol for the calls.

The options expire June 21.

If you want to follow along, grab the popcorn and go to Twitter because that’s the closest place to matching the tempo of the stock. Twitter during live events like sports is when it’s the most fun. GME is the financial equivalent of the Bills/Chiefs playoff game from a couple of years ago.

If you do go on Twitter, bring an umbrella. There appears to well-trafficked section of option twitter where I don’t follow anyone who even follows its furus. And I follow a lot of accounts. I call it wario twitter. It looks like a shortcut to making yourself dumber.

Options are a vast world. There is so so much I don’t know despite probably forgetting more about options than most people will ever learn. This is a twitter list of people I’m mostly certain are or were professionals and know what they’re talking about. I find it useful, I hope you do too.

This account, @0xfdf is relatively new and putting out a lot of great posts. This one is especially thoughtful and the principles within it can extend to many careers.

A thread on how I interview and hire quants

In related news, Euan Sinclair is going to be publishing again at Hull Tactical. I signed up for email updates. Euan is in the sweet spot of practical and technical. (See my notes on his book Positional Options Trading)

From My Actual Life

My wife and I met on my birthday in July 2003. I’ve waited 21 years for this moment.

Stay Groovy

☮️

Moontower Weekly Recap

Impedance Mismatch

In the notes I call The Essential Paul Graham I saved this passage:

What I’ve learned since I was a kid is how to work toward goals that are neither clearly defined nor externally imposed. You’ll probably have to learn both if you want to do really great things.

The most basic level of which is simply to feel you should be working without anyone telling you to. Now, when I’m not working hard, alarm bells go off. I can’t be sure I’m getting anywhere when I’m working hard, but I can be sure I’m getting nowhere when I’m not, and it feels awful.

There wasn’t a single point when I learned this. Like most little kids, I enjoyed the feeling of achievement when I learned or did something new. As I grew older, this morphed into a feeling of disgust when I wasn’t achieving anything. The one precisely dateable landmark I have is when I stopped watching TV, at age 13. Several people I’ve talked to remember getting serious about work around this age. When I asked Patrick Collison when he started to find idleness distasteful, he said:

“I think around age 13 or 14. I have a clear memory from around then of sitting in the sitting room, staring outside, and wondering why I was wasting my summer holiday.”

Perhaps something changes at adolescence. That would make sense.

A “feeling of disgust when I’m not achieving anything”.

This resonates.

But this is not a hustle-post. I’m not Gary Vee. I’m just someone who wants to save you (or someone you are guiding in life) unnecessary frustration and ultimately time by learning from my own mistakes.

The idea starts with a set of personal observations:

  1. I hate deadlines. School stresses me out. Yet deadlines were effective because I’m the type if you need something done by Wednesday you get it on Tuesday. Self-governance is not an issue for me. But it’s crippling because I can’t relax if I’m on someone else’s schedule.

    (Feels like an interesting prompt for another post: Being Good At Things You Hate — The Tragedy of Orphaned Convexity)

  2. I really don’t care that much for leisurely activity. But I do care about getting things done leisurely.

I was aware of #1 by the time I was in college but not #2. This led to a giant misunderstanding about what I wanted from a career. And life.

Let’s turn to Graham again:

To do something well you have to like it. That idea is not exactly novel. We’ve got it down to four words: “Do what you love.” But it’s not enough just to tell people that. Doing what you love is complicated.

[When I was young] the world then was divided into two groups, grownups and kids. Grownups, like some kind of cursed race, had to work. Kids didn’t, but they did have to go to school, which was a diluted version of work meant to prepare us for the real thing. Much as we disliked school, the grownups all agreed that grownup work was worse, and that we had it easy.

I’m not saying we should let little kids do whatever they want. They may have to be made to work on certain things. But if we make kids work on dull stuff, it might be wise to tell them that tediousness is not the defining quality of work, and indeed that the reason they have to work on dull stuff now is so they can work on more interesting stuff later.

Once, when I was about 9 or 10, my father told me I could be whatever I wanted when I grew up, so long as I enjoyed it. I remember that precisely because it seemed so anomalous. It was like being told to use dry water. I didn’t think he meant work could literally be fun, fun like playing, it took me years to grasp that.

It was not until I was in college that the idea of work finally broke free from the idea of making a living. Then the important question became not how to make money, but what to work on. The definition of work was now to make some original contribution to the world, and in the process not to starve.

How much are you supposed to like what you do? Unless you know that, you don’t know when to stop searching. And if, like most people, you underestimate it, you tend to stop searching too early. You’ll end up doing something chosen for you by your parents or the desire to make money or prestige, ore sheer inertia….

…Doing what you love doesn’t mean do what makes you happiest this second, but what will make you happiest over some longer period. Unproductive pleasures pale eventually. After a while, you get tired of lying on the beach. If you want to stay happy, you have to do something.

All this wisdom eluded me in my formative years. All I knew was that feeling:

Grownups, like some kind of cursed race, had to work. Kids didn’t.

Drenched in that feeling, my last summer before college was not to be wasted on drudgery but a last hurrah of a carefree existence.

As my junior year of college rolled around I had to think about my future with urgency. What was I going to do with my life? You can ask my mother, what I told her:

“I’ll be retired by 40”

I was grateful for my immigrant parents’ joyless sacrifices but determined not to repeat it. I wanted the fastest path to riches with the least amount of work. Trading was a job that rewarded working smart not hard.

[This was mostly true back then which is not fashionable to say. My peak effort moment of my career was when I joined Parallax and had to build from scratch — 12-14 hour days but for 1 year before I could dial back to an 8-9 hour gig — still way less than most high-performing finance people plus zero travel. The career didn’t feel like hard work — it felt like playing a game. It’s frustrating, but you’re not digging holes in the sun.]

Trading also had another nice feature that suited me. It’s a bell-to-bell job. And there’s lots of dull downtime in a trading day. You can use that time to build models or research so you have school hours without homework most of the time. More leisure. No deadlines really. I didn’t manage too many people. It all served what my younger self wanted.

For a while.

But that feeling of self-disgust when you’re not growing that Graham had when he was 13 started happening to me in my early 30s. Really late, I know. Until then I could play Madden for 8 hours straight and feel fine.

What changed?

A lot in a short period.

For starters, I got a 1-handle bonus when I was 29. I quit immediately after they paid it. The money felt nice for a second. I bought a bigger apartment. I had an open-ended job in-hand. Prime International, with the backing of 2 of its senior traders, said they would back me to start a nat gas options market-making business. I told them I was gonna go screw off for awhile and they said the spot would be there whenever I was ready. I took the Spring and Summer of 2008 off. Traveled a bit, got in shape, proposed to Yinh in Napa in August.

I got back to NYC just as autumn was announcing its arrival. I’m bored now. I called Prime. “How long’s it gonna take to get my account set up?”

Like I said in the last issue, the next 3+ years were the steepest learning of my career. I was building the framework that eventually led to my business pitch to Parallax.

By 2011, I was also itching to produce not just consume. I started a blog called Shoxland (named after my trading floor badge SHOX). I published for a few months — the posts I remember best, which is to say not well, was on how newly IPO’d Groupon synthetic futures were priced in the option market and another about how high implied correlation was trading in the SPX (how times have changed!)

I enjoyed writing but between not having an audience and the impending move to SF for the Parallax job, Shoxland just trailed off.

[The writing thing wasn’t completely out of nowhere. I had an unusually large vocabulary by age 12, I picked college courses that graded me on writing because I knew that was my best chance for A’s, and this is more cringe than signal, but I scored a 790 on my SAT II writing which was the top score in my HS. None of this is evidence of any actual skill, but my inner narrative told me there was a plant bending towards sunlight and I should at least raise the blinds].

Picking up the Parallax job with actual developer resources behind me let me wear a dual PM hat — portfolio manager and project manager. Building on this stage was a new feeling. Generative. It had higher stakes — I was asking people to trust me not just with capital but with hundreds of hours of developer time from people I really liked and wanted to succeed.

I felt like a grown-up for the first time…at age 34. Incidentally, On my 35th birthday, we went to the hospital to have a son. Adulting came late, but all at once.

About a year later I went to the internet to learn about investing. I wrote all about that in My Investing Shame Is Your Gain. Everything about my mindset shifted from the transactional and quick-hit to the cliche — compounding.

I started indulging a lot of latent urges that in prior times didn’t seem to have a point because I couldn’t see the payoff right away.

I took copious notes. I built a personal knowledge management (PKM for productivity nerds) system. It didn’t need a goal. It just fed a sense of growth and learning. I didn’t care that there was no obvious instrumental angle.

But as serendiptiy would have it, collecting ideas by topics led to arguing with myself. Trying to understand contradictions. Looking for ways to communicate concepts back to myself in ways that would stick.

All of it would point straight to Moonotwer. Accident after accident. Just producing for the fun of it and letting the work lead me.

Graham feels icky when he isn’t achieving. I’m not there. But I feel icky when I’m not learning or producing. The Moontower deadlines balance how often I can publish without feeling like a chore (and I do take a couple weeks off in the summer and holiday season). Truthfully, it is sometimes a chore but the cadence is such that if I didn’t publish on this schedule I’d get down on myself for not learning at a pace that is necessary to support it. It’s a deadline that my better self requires of my lazy self imposed by an internal governor who knows I’ll regret letting the lazy self have his way.

If I can work at my pace I set, if I feel in control, the work is nourishing. I’ll trade money for independence. But I didn’t understand that you could arrive at such a place when I thought about how careers go. I had a rigid understanding of work — cash for torture or unabated freedom. Neither of those choices are healthy and yet they’re the only ones I conceived. It’s so stupid, it feels insane to admit.

So what should you take away?

The rhythm of school and many jobs leads you to misunderstand how you feel about work. It’s not Work with a capital W you hate. It’s an impedance mismatch leading to inefficient power transfer as opposed to a complete short circuit.

You hate alarm clocks. Or commuting. Or taking orders. Or giving orders. Or constant deadlines. Or not being accountable. Or not thinking your work matters. Or that it’s poorly matched to your skills. Or it’s not outdoors enough. Or you travel too much. Or you don’t get to travel at all. Or you can’t steal an hour to volunteer at your kid’s Field Day.

When I was young, my model for work was joyless sacrifice. This led me to ignore compounding because it was a naively forgone conclusion that I couldn’t suffer long enough to see its benefits. This meant those fleeting bouts of free time were the only time I could be alive. That time was to be used in ways that didn’t resemble work. This created an adversarial relationship between my 2 selves. When I laid it out like that it was clear — there must be a better mix of compromises on the work-life frontier.

Finding it is a technical problem. Ignoring the possibility becomes an existential one.

 

🔗Read more

  • If you want to read more on aligning what you do with your own sense of vitality see Design Your Own Engine.

    The sales pitch for that post: It’s probably under-read because it’s long but it’s one of those posts that multiple readers credited for compelling them to become paying subs. I’ve even had 2 people come meet me in person to talk about it.

🛡️Anticipating rebuttals

  • Some might argue that work is just a job and my attitude asks too much of it. That’s up to you. There are many ways to live. I can point you to many examples of people who look forward to Mondays.

    There’s a quote by the advertising guy Ogilvy in his book where he sees an employee go home and unironically marvels…”Imagine the discipline it must take to leave the office right at 5pm”.

    I felt exactly like that when I started at Parallax. I enjoyed those hours of being the last person in the office, able to work interrupted. But I lost the love.

    The person who sees a large block of time on the calendar and thinks “I can’t wait to fill it with [insert work project]” is a fortunate individual.

  • The privilege argument…Of course, I’m aware that many people have little choice. Sandwiched between martyrdom and negligence. My wife and I both have parents with similar stories. I get it. But most people reading a substack let alone this substack aren’t behind that particular 8-ball. The fastest way to siphon all joy and value from communication is to go on as if all 8 billion people on Earth are in the room. Nobody wants 3 pages of pharma disclaimers at the end of a blog post
  • On the poor strategic decision to let my own writing be seen side-by-side with Paul Graham’s…it was a vicious miscalculation on my part. Take heart my eyes hurt more than yours.

Moontower #230

Friends,

In the notes I call The Essential Paul Graham I saved this passage:

What I’ve learned since I was a kid is how to work toward goals that are neither clearly defined nor externally imposed. You’ll probably have to learn both if you want to do really great things.

The most basic level of which is simply to feel you should be working without anyone telling you to. Now, when I’m not working hard, alarm bells go off. I can’t be sure I’m getting anywhere when I’m working hard, but I can be sure I’m getting nowhere when I’m not, and it feels awful.

There wasn’t a single point when I learned this. Like most little kids, I enjoyed the feeling of achievement when I learned or did something new. As I grew older, this morphed into a feeling of disgust when I wasn’t achieving anything. The one precisely dateable landmark I have is when I stopped watching TV, at age 13. Several people I’ve talked to remember getting serious about work around this age. When I asked Patrick Collison when he started to find idleness distasteful, he said:

“I think around age 13 or 14. I have a clear memory from around then of sitting in the sitting room, staring outside, and wondering why I was wasting my summer holiday.”

Perhaps something changes at adolescence. That would make sense.

A “feeling of disgust when I’m not achieving anything”.

This resonates.

But this is not a hustle-post. I’m not Gary Vee. I’m just someone who wants to save you (or someone you are guiding in life) unnecessary frustration and ultimately time by learning from my own mistakes.

The idea starts with a set of personal observations:

  1. I hate deadlines. School stresses me out. Yet deadlines were effective because I’m the type if you need something done by Wednesday you get it on Tuesday. Self-governance is not an issue for me. But it’s crippling because I can’t relax if I’m on someone else’s schedule.

    (Feels like an interesting prompt for another post: Being Good At Things You Hate — The Tragedy of Orphaned Convexity)

  2. I really don’t care that much for leisurely activity. But I do care about getting things done leisurely.

I was aware of #1 by the time I was in college but not #2. This led to a giant misunderstanding about what I wanted from a career. And life.

Let’s turn to Graham again:

To do something well you have to like it. That idea is not exactly novel. We’ve got it down to four words: “Do what you love.” But it’s not enough just to tell people that. Doing what you love is complicated.

[When I was young] the world then was divided into two groups, grownups and kids. Grownups, like some kind of cursed race, had to work. Kids didn’t, but they did have to go to school, which was a diluted version of work meant to prepare us for the real thing. Much as we disliked school, the grownups all agreed that grownup work was worse, and that we had it easy.

I’m not saying we should let little kids do whatever they want. They may have to be made to work on certain things. But if we make kids work on dull stuff, it might be wise to tell them that tediousness is not the defining quality of work, and indeed that the reason they have to work on dull stuff now is so they can work on more interesting stuff later.

Once, when I was about 9 or 10, my father told me I could be whatever I wanted when I grew up, so long as I enjoyed it. I remember that precisely because it seemed so anomalous. It was like being told to use dry water. I didn’t think he meant work could literally be fun, fun like playing, it took me years to grasp that.

It was not until I was in college that the idea of work finally broke free from the idea of making a living. Then the important question became not how to make money, but what to work on. The definition of work was now to make some original contribution to the world, and in the process not to starve.

How much are you supposed to like what you do? Unless you know that, you don’t know when to stop searching. And if, like most people, you underestimate it, you tend to stop searching too early. You’ll end up doing something chosen for you by your parents or the desire to make money or prestige, ore sheer inertia….

…Doing what you love doesn’t mean do what makes you happiest this second, but what will make you happiest over some longer period. Unproductive pleasures pale eventually. After a while, you get tired of lying on the beach. If you want to stay happy, you have to do something.

All this wisdom eluded me in my formative years. All I knew was that feeling:

Grownups, like some kind of cursed race, had to work. Kids didn’t.

Drenched in that feeling, my last summer before college was not to be wasted on drudgery but a last hurrah of a carefree existence.

As my junior year of college rolled around I had to think about my future with urgency. What was I going to do with my life? You can ask my mother, what I told her:

“I’ll be retired by 40”

I was grateful for my immigrant parents’ joyless sacrifices but determined not to repeat it. I wanted the fastest path to riches with the least amount of work. Trading was a job that rewarded working smart not hard.

[This was mostly true back then which is not fashionable to say. My peak effort moment of my career was when I joined Parallax and had to build from scratch — 12-14 hour days but for 1 year before I could dial back to an 8-9 hour gig — still way less than most high-performing finance people plus zero travel. The career didn’t feel like hard work — it felt like playing a game. It’s frustrating, but you’re not digging holes in the sun.]

Trading also had another nice feature that suited me. It’s a bell-to-bell job. And there’s lots of dull downtime in a trading day. You can use that time to build models or research so you have school hours without homework most of the time. More leisure. No deadlines really. I didn’t manage too many people. It all served what my younger self wanted.

For a while.

But that feeling of self-disgust when you’re not growing that Graham had when he was 13 started happening to me in my early 30s. Really late, I know. Until then I could play Madden for 8 hours straight and feel fine.

What changed?

A lot in a short period.

For starters, I got a 1-handle bonus when I was 29. I quit immediately after they paid it. The money felt nice for a second. I bought a bigger apartment. I had an open-ended job in-hand. Prime International, with the backing of 2 of its senior traders, said they would back me to start a nat gas options market-making business. I told them I was gonna go screw off for awhile and they said the spot would be there whenever I was ready. I took the Spring and Summer of 2008 off. Traveled a bit, got in shape, proposed to Yinh in Napa in August.

I got back to NYC just as autumn was announcing its arrival. I’m bored now. I called Prime. “How long’s it gonna take to get my account set up?”

Like I said in the last issue, the next 3+ years were the steepest learning of my career. I was building the framework that eventually led to my business pitch to Parallax.

By 2011, I was also itching to produce not just consume. I started a blog called Shoxland (named after my trading floor badge SHOX). I published for a few months — the posts I remember best, which is to say not well, was on how newly IPO’d Groupon synthetic futures were priced in the option market and another about how high implied correlation was trading in the SPX (how times have changed!)

I enjoyed writing but between not having an audience and the impending move to SF for the Parallax job, Shoxland just trailed off.

[The writing thing wasn’t completely out of nowhere. I had an unusually large vocabulary by age 12, I picked college courses that graded me on writing because I knew that was my best chance for A’s, and this is more cringe than signal, but I scored a 790 on my SAT II writing which was the top score in my HS. None of this is evidence of any actual skill, but my inner narrative told me there was a plant bending towards sunlight and I should at least raise the blinds].

Picking up the Parallax job with actual developer resources behind me let me wear a dual PM hat — portfolio manager and project manager. Building on this stage was a new feeling. Generative. It had higher stakes — I was asking people to trust me not just with capital but with hundreds of hours of developer time from people I really liked and wanted to succeed.

I felt like a grown-up for the first time…at age 34. Incidentally, On my 35th birthday, we went to the hospital to have a son. Adulting came late, but all at once.

About a year later I went to the internet to learn about investing. I wrote all about that in My Investing Shame Is Your Gain. Everything about my mindset shifted from the transactional and quick-hit to the cliche — compounding.

I started indulging a lot of latent urges that in prior times didn’t seem to have a point because I couldn’t see the payoff right away.

I took copious notes. I built a personal knowledge management (PKM for productivity nerds) system. It didn’t need a goal. It just fed a sense of growth and learning. I didn’t care that there was no obvious instrumental angle.

But as serendiptiy would have it, collecting ideas by topics led to arguing with myself. Trying to understand contradictions. Looking for ways to communicate concepts back to myself in ways that would stick.

All of it would point straight to Moonotwer. Accident after accident. Just producing for the fun of it and letting the work lead me.

Graham feels icky when he isn’t achieving. I’m not there. But I feel icky when I’m not learning or producing. The Moontower deadlines balance how often I can publish without feeling like a chore (and I do take a couple weeks off in the summer and holiday season). Truthfully, it is sometimes a chore but the cadence is such that if I didn’t publish on this schedule I’d get down on myself for not learning at a pace that is necessary to support it. It’s a deadline that my better self requires of my lazy self imposed by an internal governor who knows I’ll regret letting the lazy self have his way.

If I can work at my pace I set, if I feel in control, the work is nourishing. I’ll trade money for independence. But I didn’t understand that you could arrive at such a place when I thought about how careers go. I had a rigid understanding of work — cash for torture or unabated freedom. Neither of those choices are healthy and yet they’re the only ones I conceived. It’s so stupid, it feels insane to admit.

So what should you take away?

The rhythm of school and many jobs leads you to misunderstand how you feel about work. It’s not Work with a capital W you hate. It’s an impedance mismatch leading to inefficient power transfer as opposed to a complete short circuit.

You hate alarm clocks. Or commuting. Or taking orders. Or giving orders. Or constant deadlines. Or not being accountable. Or not thinking your work matters. Or that it’s poorly matched to your skills. Or it’s not outdoors enough. Or you travel too much. Or you don’t get to travel at all. Or you can’t steal an hour to volunteer at your kid’s Field Day.

When I was young, my model for work was joyless sacrifice. This led me to ignore compounding because it was a naively forgone conclusion that I couldn’t suffer long enough to see its benefits. This meant those fleeting bouts of free time were the only time I could be alive. That time was to be used in ways that didn’t resemble work. This created an adversarial relationship between my 2 selves. When I laid it out like that it was clear — there must be a better mix of compromises on the work-life frontier.

Finding it is a technical problem. Ignoring the possibility becomes an existential one.

 

🔗Read more

  • If you want to read more on aligning what you do with your own sense of vitality see Design Your Own Engine.

    The sales pitch for that post: It’s probably under-read because it’s long but it’s one of those posts that multiple readers credited for compelling them to become paying subs. I’ve even had 2 people come meet me in person to talk about it.

🛡️Anticipating rebuttals

  • Some might argue that work is just a job and my attitude asks too much of it. That’s up to you. There are many ways to live. I can point you to many examples of people who look forward to Mondays.

    There’s a quote by the advertising guy Ogilvy in his book where he sees an employee go home and unironically marvels…”Imagine the discipline it must take to leave the office right at 5pm”.

    I felt exactly like that when I started at Parallax. I enjoyed those hours of being the last person in the office, able to work interrupted. But I lost the love.

    The person who sees a large block of time on the calendar and thinks “I can’t wait to fill it with [insert work project]” is a fortunate individual.

  • The privilege argument…Of course, I’m aware that many people have little choice. Sandwiched between martyrdom and negligence. My wife and I both have parents with similar stories. I get it. But most people reading a substack let alone this substack aren’t behind that particular 8-ball. The fastest way to siphon all joy and value from communication is to go on as if all 8 billion people on Earth are in the room. Nobody wants 3 pages of pharma disclaimers at the end of a blog post
  • On the poor strategic decision to let my own writing be seen side-by-side with Paul Graham’s…it was a vicious miscalculation on my part. Take heart my eyes hurt more than yours.

Refer a friend

Money Angle

In The Investing Version Of “Nothing Good Happens After Midnight” I talk about my own philosophy that investing should really be thought of as “savings plus” rather than a means to get rich. Keep your wealth pacing with inflation and let your human capital, an area where you possess both “specific knowledge” and “accountability” (to use Naval Ravikant lingo), create upside asymmetry. For 99% of people secondary market investing is a just a high risk/reward roulette wheel when you start sizing concentrated risk.

Jared Dillian’s recent post Life Hedge completes many of my own thoughts but with his trademark flair.

Money Angle For Masochists

Saw this on Twitter:

https://x.com/dampedspring/status/1790489354508341539

I wrote an explainer later that day:

https://x.com/KrisAbdelmessih/status/1790537275736223837

The thread breaks it down and uses Moontower Volatility Converter to do the calculations.

From My Actual Life

My eldest finished elementary school this past week. All the kids in the class wore these shirts at the ceremony.

My opinion on this one:

https://x.com/KrisAbdelmessih/status/1796926714326774244

I have a tedious history with this particular sentiment. See My Personal Trigger if you care.

Stay Groovy

☮️

a birdie asked how to model a 1-day option

It’s going to shock you to hear it, but I get emailed a lot of option questions. I’ve gotten some that are pages long with commentary, prices, blood type.

This is one of the reasons I put the shingle up for calls. I’m definitely not reading all that free, but also I can talk through options stuff way faster than I can read and write about it. You’ll say 500 words about what your doing and I’ll collapse it into floor trader grunts in the time it takes to pick up a handset and say “sold”.

I spent my whole adult life having to make option decisions in a few seconds. This is not anything special — talk with any market-maker and their fluency with calls and puts seems like a parlor trick. Options are just another language and being fluent in it means you think in that language natively. The old floor folk can even sign in options as fast as you can talk. (I can read the signing but I was the tail end of futures being traded in the pit and not on Globex. I never developed a large hand signal vocabulary).

That said, if a sub sends me a question that I can peck on my phone in a few minutes I’ll just answer it. (Also I read every email I get and try to respond to all of them even if it’s to acknowledge that both I and the sender are humans worthy of not being ignored.)

If responding to an email takes more than a few minutes I’ll pass it through the “would other people care about the answer to this question?” filter. If so, I can kill 2 birds with one stone. Oh my god, F me that’s a horrid idiom. The first person who ever said that should have been locked up on the spot cause that’s I-knew-he-was-a-serial-killer-when-he-was-nine level of clue. I never thought about the literal meaning of that expression until I typed it.

Re-phrasing — today is one of those moontowers where I can pick up the 7-10 split by sharing a response to a reader question that you might find useful.

Reader question:

Do you know of any way to model an option’s price intraday?

My response:

2 things I’d think about:

1. Intraday I would think in terms of straddle prices and price changes and compare that to tick vols (but the tick vols themselves can also be in price space not vol space)

2. Modelling the fraction of a day’s variance that typically accumulates every hour (for example the open represent more of the days volatility then any random 15 minute interval)

Reader reply:

When you say you would think in terms of straddle prices and price changes, how would that be used to model the price of a specific option? For example, if someone wanted to model the price of the 190 strike call 5/24 by the hour tomorrow relative to AAPL’s price, what should they do to get a rough idea? 

 

I’d start with the question of:

“What do you think the straddle is worth every hour?”

A straddle represents the mean absolute deviation (MAD) which is 80% of the volatility or standard deviation of return.

If you think AAPL moves 1% per day then the straddle is worth 1% at the start of the day. If strike is ATM then the call is worth 50 bps.

The value of the straddle changes by root time (assuming vol is unchanged).

[See Visual Derivation Of The Straddle Approximation]

So if half the day is gone, the straddle is worth: 1% * sqrt(.5) = .71%

The question is at what time do you think only 1/2 the day’s volatility remains?

This question applies to every hour of the day.

The entire concept of “intraday decay curves” is area of active inquiry for any market-maker so I don’t have an answer key but the problem is familiar.

In practice, I’ve tackled this with a blend of lazy guessing and leaning on some quant research.

The lazy way

The 80/20 solution or guess would be to assume volatility transpires at the same rate volume unfolds over the course of the day.

I prompted perplexity.ai with “vwap volume distribution over the day”. To my delight it didn’t send me down the circus internet, but actually said something smart:

The volume-weighted average price (VWAP) is calculated by dividing the total dollar amount traded for a security over a specific time period by the total volume traded during that same period. This means that prices at which larger volumes were traded have a greater impact on the VWAP calculation than prices with smaller volumes.

To calculate VWAP accurately, it is important to consider the volume distribution over the trading day. Historically, volume is not evenly distributed throughout the day – there are typically periods of higher and lower trading activity.

Many trading algorithms account for this by using historical volume profiles to predict the expected volume distribution over the upcoming trading day. The algorithm then slices the total order into smaller “child orders” that are released at predetermined times based on the forecasted volume distribution.

For example, if 17% of the day’s total volume historically trades in the first hour, the algorithm would aim to execute 17% of the total order during that first hour period.

Get your hands on historical volume profiles and you have a solid start. VWAP algos are commoditized and rest on that research so it shouldn’t be hard to track down.

The quant way

You can use tick data to compute realized variance for each hour and divide by the sum of all the variances for the day to see the proportion by interval. You can use many days data as well as many names to get a cross-sectional perspective.

You will need to treat the period from the prior close to the open in some coherent manner as well. Like you could take the point-to-point variance from the previous close to open divided by the close to close variance over many samples and names and then you can make a statement like “25% of the variance happens overnight.”

That means the remaining hourly variances are then divided by a variance of only .75 of the expected daily variance. Over many days of doing this you will likely get a strong sense of when on average half a day’s variance has transpired.

Extra thoughts

 

  1. Computing tick vols is a quant rabbit hole of its own. When you come across the words “bid-ask bounce” and “volatility signature plot” you are reading the right stuff.
  2. I’m not a quant researcher. I’m a hacker. I throw numbers in spreadsheets or if I’m really ambitious Python, and turn the crank until I see the shape of the problem. So my methodology above is a zoomed out answer but once you make contact with data the specific details will not go smoothly. Nature of the beast. But the approach is directionally correct you just have to savor the data-wrangling gruel. For example, how many data points are enough? I don’t know — keep adding more until the variations in proportions seem to stabilize at some quantity.

    An instinct one develops with enough practice is to know whether your cobbled-together “tape and twine” analysis has a rigor that is proportional to required precision of your use-case. If whatever I’m doing is going to break because I don’t truly understand what “degrees of freedom” means then I just need enough taste to know that I should get a quant’s help.

    Discerning how rigorous you need to be is part of being an efficient resource allocator. How much time do you spend on pricing vs execution vs figuring out how to hedge less vs exploring names like not AAPL or other high volume names where Citadel & SIG’s market-makers are trading from the cockpit of F-22s?

What Equity Option Traders Can Learn From Commodity Options

GME share price started the month around $11. On Friday May 10th, it closed $17.46. Monday it was about 80% to $31. Tuesday it climbed >50% closing at $48.75 before it would give back over half its gains just as quickly.

In a twitter thread @DeepDishEnjoyer, a former market-maker, called attention to what happened with the July expiry $10 strike put — despite a huge rally the put went up in value. Obviously implied volatility exploded.

Let’s follow along in the thread:

This is quite odd from a first principles perspective. GME closed 17 handle on Friday. Today it meme squeezed up because of Roaring Kitty. A basic model is: it continues meme’ing – then these puts expire worthless or the meme ends and we go back to where we were at at Friday. But note that you could have sold these puts at 75 cents today even though they closed in the 50s on Friday!!!! They should be actually be worth *less* since there is no state of the world where downside vol increased.

He continues:

That’s easily anywhere from 20-40 cents of EV on these puts. And indeed that’s where these puts landed now. So why does it happen? Well, market makers don’t pay a large amount of attention to the wings of their vol surface. ATM implied vol got correctly bid, but they moved the…rest of the surface in parallel EVEN THOUGH THAT MAKES NO SENSE IN A SCENARIO WHERE A STOCK MEME GAPPED UP. Again, vol follows fairly two discrete paths that are intimately tied to stock price – vol is high when the stock is memeing, vol necessarily dies down when it stops.

At the money implied vol should increase. But the strike vol of the 10 strike put should not be massively increasing as the probability of going *below* 10 has not increased today from yesterday, while the options market is implying it has.

So did the IV on those puts go up “too much”?

Settle in. Lots to discuss.

I used the price chart of the put to price the options with a Black Scholes European-style calculator (the American/European thing isn’t important for this).

We start with May 10th just to establish the first elevated IV before stepping through the insanity of the May 13th morning.

It’s a bit hand-wavey since I didn’t know where the spot price was with every corresponding put price on that Monday morning. I assume the put price surged and eased while the spot price remains at $31. The illustration will be valid even if the exact numbers aren’t.

The put price on May 13

For the next section, keep in mind that N(d2) represents probability of option expiring in-the-money.

Stepping through the option prices…

@DeepDishEnjoyer said at $.75 the put implied an even higher chance of going in the money with the stock at $31 than it did when the stock was $17.50.

That checks out in the option model.

It also reflects experienced intuition by DeepDishEnjoyer because I doubt he manually computed N(d2).

The option beginner could have exclaimed “the implied probability isn’t higher — the delta of the put went from .08 to .04!” If you’ve been at the moontower for awhile you understand in high volatility names delta does not equal probability (if you are a new reader then I point you to a top-5 most read post: Lessons From The .50 Delta Option).

When the vol eases back to 175%, still higher than the previous day but off the high, the put’s probability falls to 14% (and the delta falls meagerly from .04 to .03).

Our twitter friend used a sense of implied probability to conclude that the put price expanded too much. And because he says:

there’s easily anywhere from 20-40 cents of EV on these puts. And indeed that’s where these puts landed now

I can infer that while he thought the $.75 price was too high, he may not have a strong opinion on the $.40 price. A price that still represents a much higher IV (175%) vs Friday (112%).

Smacks of a lot of experience. It was also a slightly different way than I would have thought about it.

How my instincts work in such situations

My reflex is also to think in terms of probability. However, I don’t reach for an N(d2) calculator.

I look at put spreads. Tradeable odds.

When DeepDishEnjoyer says the $.75 price is too high a probability, he’s collapsing a lot of compiled mental code into a comment. It’s worth unwrapping.

The price of an option reflects the probability of going in the money as well as how far ITM it can go. The divergence of the delta and N(d2) is model-based clue — since the maximum payoff on that put is capped at $10 then the exploding IV is mostly operating on the probability portion.

My native instinct when thinking about probability is to look at the put spreads since verticals are model-free over/under style bets.

See:

When I think “The $10 put is too high” I hear 2 possibilities:

a) The volatility is too high

or

b) There is a slab of put spreads on the surface that are too cheap where you should buy a higher strike put and sell the expensive $10 put. In this case, you believe the probability of finishing in the money for the $10 put is too high, but the implied probability of the stock going back to $10 is too low.

In other words, we get option trades ideas that are in opposition!

  • If you believe volatility is too high you should consider selling at-the-money options which have more vega and at least locally less exposure to high-order moments. (Since the market is volatile, you might sell straddles, see the stock move, and your options become OTM, leaving you exposed to those higher-order moments anyway.)
  • If you think the $10 put is too high, and buy a put spread because you think the implied probability of going to $10 is underpriced. But this is a long vol position.

This is the $20 put if you priced it at 206% vol as well.

Notice how the probability of going ITM is 49% despite the strike being 33% out-of-the-money. Again, even though the probability looks high at nearly 50%, the delta is only .17

So how do we parse this?

We agree the $10 put is too high at $.75…do we sell it as the short leg of a put spread offering 1.8 to 1 on the meme situation ending by mid-July?

The price action looks like that $.75 print was fleeting and likely hard to get on. I doubt the market-makers mispriced it so much as recognized that buyers on a Monday morning could be sloppy traders thinking “I’m buying puts because this stock action is dumb” and were directionally aware but not vol aware. Rip the surface up, print the customers, take it back down to a spot that balances a more level-headed meeting price of buyers and sellers.

It’s hard to disagree with DeepDishEnjoyer. The puts were an outright sale. Probably hard to execute in the fleeting window but the point stands.

The way this situation unfolded, the speed of the rally, occurrence over a weekend, and retrace within a few days reminds me of early 2021 when SLV got aped from about $24 to $27 for a hot second.

The vols blew out across the surface (especially the calls) and I had exactly the same response as DeepDishEnjoyer — sell the downside puts.

Unfortunately…

SLV did a great job pricing them. The best you could get on the 27/24 put spread was an even money payout on the stock retracing back to 24. Any “normal” surface would give you pretty nice odds of a stock falling 10% but the surface was telling you that a 10% sell-off was “home”.

The put vols way underperformed the ATM and call vols. The market understood that those puts were trash and didn’t bid them up. Which made the put spreads, the structure you want to buy, a well-priced risk/reward. Nothing to see here.

The up move in SLV was not as extreme as GME. The vol expansion was only a doubling from about 35 to 70. So those OTM puts weren’t suddenly more expensive than they were pre-move. They just weren’t down as much as you’d expect.

If the stock went back down you would have lost on an unhedged basis. If were hedged then you risk the stock rallying further. And then if you did hedge and the stock fell what delta would you want to be short on? The p/l from a well-priced option trade is just path noise with no compensation.

Here’s a scenario any experienced option trader will relate to:

The stock sells off moderately, the vol comes in, which pushes that strike further OTM and the strike vol rolls up the skew curve as the option goes from say 20 delta to 5 delta despite becoming closer in moneyness. You’ll win on this move, but not as much as you’d like, and if you decide to cover the teeny put when you cover your stock shares you’ll pay a small exit tax on the way out. None of this will have felt worth the brain damage because the option market got it right from the start.

[There was a fleeting moment of edge in all this — there was a window of call buying at over 110% after the open that later settled in to being 90% IV for the next few days. If you missed that window, sure you could have sold 90% vol and thought that was high but you’re basically trading at fair value because there was liquid flow at both sides of that level.

Note the similarity to the GME puts. A fleeting window in the am before options settle into fair. The lesson — only trade a fast market on the open if you want to be a hero and willing to risk being a donkey. Unfortunately, getting filled is not a good sign. If you’d prefer a “fairer” execution you should wait.]

Commodity markets as teachers

I went for a hike during that SLV week with friend who runs a commodity vol fund. We had this moment:

I restored in HD 4k the original "Spider-Man Pointing at ...
“You wanted to buy put spreads and passed too?!”

We had the same instincts. And the same conclusion. Sell the puts, doh, they don’t look expensive compared to the rest of the surface, dammit, I hate this place.

We joked about how anyone who has ever traded nat gas has these same instincts. It can be April, gas futures for the upcoming Winter could be $8 and no matter which put spread you try to buy to bet gas goes right back to $3 by expiry pays no more than 3-to-1. If you have no frame of reference for odds…imagine being paid only 3-to-1 on a 63% selloff.

I’m looking at Jan25 options in ARKK right now. The 23/17 put spread costs about $.20 with the stock at $45. This spread can be worth $6. You’re getting 29-to-1 on a 63% selloff.

The other joke we made is that in commodities you find these regimes where wingy options just don’t change in price unless insanity happens. Your model says the option has a 5d but the experience is they behave on a 0 delta. This sound ridiculous until you watch people blow out because they have this wrong (nat gas is full of stories of people getting rinsed owning puts on massive selloffs including a large mm).

As a trader, when you see a crazy situation like a meme-stock, it’s useful to ask yourself — what market regularly has this behavior? Is it a market with lots of volume, a centralized/transparent order book, and 20+ years of institutionalized tacit knowledge of how to price options on such weirdness? Nat gas says “check, check and check”.

When a meme stock squeezes, does JANE SIGCIT just yell turn off “equity sheets run gas skew in GME?”

It’s not total overlap but a squeeze is balancing the same forces I explain in What The Widowmaker Can Teach Us About Trade Prospecting And Fool’s Gold:

The truth is the gas market is very smart. The options are priced in such a way that the path is highly respected. The OTM calls are jacked, because if we see H gas trade $10, the straddle will go nuclear.

Why? Because it has to balance 2 opposing forces.

  1. It’s not clear how high the price can go in a true squeeze or shortage
  2. The MOST likely scenario is the price collapses back to $3 or $4.

Let me repeat how gnarly this is.

The price has an unbounded upside, but it will most likely end up in the $3-$4 range.

Try to think of a strategy to trade that.

Good luck.

  • Wanna trade verticals? You will find they all point right back to the $3 to $4 range.
  • Upside butterflies which are the spread of call spreads (that’s not a typo…that’s what a fly is…a spread of spreads. Prove it to yourself with a pencil and paper) are zeros.

As a matter of prospecting, you can expect that each time a market starts “meme’ing” the playbooks become more obvious for the surface setters. That said, market-makers are exceptional pattern-matchers so if you have a reason why a familiar setup will have a different endpoint, you’ll be able to find great prices. But if you have the consensus “this thing is headed back home” view know that the prices already reflect that. You’re just tossing coins for even money.

GME was Groundhog’s Day. This is from the 2021 post How Options Confuse Directional Traders:

SLV downside

We’re going to come back to silver again in a moment.

In all this writing, I hope the message is coming across — you should not touch options if you have a directional opinion but not a vol opinion.

On Monday, we held the moontower.ai community zoom. We talked about the newly released Moontower Mission Plan series. The core goal of the series is to walk a user through the process of developing a volatility opinion (or “axe” as in “axe to grind” — trading lingo).

As we walked through the steps, I found that SLV near-dated downside (ie 1 month) looked like a sale.

The IV was elevated and the term structure strongly descending so we proposed selling near-dated…

…but then we check the VRP (volatility risk premium) to see how the IV looked compared to recent realized vol and found a healthy amount of carry.

So we like selling near-dated SLV vol.

Now SLV has been rallying along with GLD. This thread by @SantiagoAuFund makes the case for a tactical short directional position in silver. The sentiment and COT positioning reasons are the ones that resonate most with me.

[Plus the fact that he’s being attacked for being bearish. I like when a trade offends people — if everyone is bulled up then the market is more likely to compensate the sellers since that’s whose service is needed. And if positioning indicates that speculators are already very long, then that’s embedded in the current price plus there’s less people left to buy. I hold no long term view on silver — I just like the tactical idea.]

Santiago expressed his bet via buying puts. This is where we differ. SLV vol looks like a sale so I want to express the bearish directional view in a short vol way. I also prefer simplicity. So I’d limit the trade expressions to:

  1. Selling ATM or ITM callsThe skew in the one month 25d puts according to our metrics is in the 47th percentile so it’s pretty fair therefore I don’t feel ripped off selling the ITM calls. (You could also sell the OTM puts and short the stock on a 1-1 ratio. It’s synthetically the same trade.)
  2. Sell straddles where the call is ITM.Same trade as the earlier one, but the initial delta is not as short (so if your directional conviction isn’t strong. Also if you sold OTM puts and hedge with half the number of shares this is synthetically an ITM straddle. The shares turn 1/2 the puts into synthetic calls. So if you sold 10 OTM puts and 500 shares your synthetically short 5 ITM straddles. Put-call parity is fun.)
  3. You could sell the calls and cap your risk by buying an OTM call.This is a short call spread. Since you are buying a higher strike call, your initial vega will not be as short. The wider the call spread the more the risk looks like a naked short call and the more short vol you are expressing (not to mention shorter deltas).
  4. A more advanced trade could be to buy 1×2 put spreadsYou could buy an ITM put to sell 2 OTM puts. You can find the strikes that dial in the desired initial delta and vega. But you can also see that this is the equivalent of buying a put spread and selling an extra OTM put. Or selling a straddle and buying a single OTM option to hedge. Options are Legos to build the structures you want, but just as a chess player chunks positions into familiar patterns, options can all be reduced to a combination of straddles and verticals (if we stick to a single expiry).

Ok, that’s enough for today.

Also, disclaim disclaim disclaim. You own your own decisions. I’m just saying what I see not recommending you do anything.

Weighting An Options Pair Trade

An option trader pinged me about a trade between a correlated pair of names whose IV ratio was trading at an extreme level compared to the ratio of realized volatilities that the pair has experienced in the past.

This trader is experienced. He understood that pitting vanilla options against one another invites path dependence. It’s worth spelling that out with a demonstration:

Imagine both assets are trading for $100 so you buy the 100 strike straddle in asset A and short the 100 strike straddle in asset B. Once these assets start bouncing around the moneyness of the straddle positions will get out of sync. After a week if both assets realize the same volatility but the path of A means it’s up 5% and the path of B means its up only 2% then you will have more gamma and theta in B because the straddle is closer to at-the-money (ATM). The further you get from a strike the more your exposure “goes away”. Far OTM options spit off smaller greeks and are less sensitive to changes in underlying price or volatility.

Let’s get to the question.

He was theta-weighting the trade instead of vega-weighting the trade. He wanted to know if I would do the same.

I’ll give examples of how each approach will end up weighting the legs, how I’d weight the trade, how to map weightings to the nature of a relationship, and even what greeks depend on.

By the time you finish this post, you will be able to understand the risks of different weightings and how to compute weightings in your head knowing nothing else except spot prices and ATM vols.

Let’s start with definitions.

Delta

Change in option price for a $1 change in the stock price

If an option has a .50 delta and the stock increases by $1, the option value increases by $.50

If it was a put option the delta would be negative. If the option has a -.50 delta and the stock increases by $1, the option falls by $.50. If the stock had fallen by $1 then the option increases in value by $.50

Vega

Change in option price for a 1 point change in the implied volatility

If an option has .20 of vega than a 1 point increase in implied vol, for example from 15% to 16%, the value of the option increases by $.20

If implied volatility fell from 15% to 14%, the option loses $.20

Gamma

The change in the delta for a $1 change in the stock price

If an option has .05 gamma and .50 delta and the option goes $1 more in-the-money then the option delta increases from .50 to .55. The option is becoming more sensitive to the stock price. As an option goes far in-the-money its delta continues to increase because of gamma until it approaches 1.00. At that point the option is so far in-the-money it moves 1-to-1 with the stock price.

If our .50 delta option with .05 gamma falls $1 out-of-the money its delta falls to .45. It becomes less sensitive to the stock price on the subsequent move. If the option continues to fall further out-of-the-money, its delta will fall to zero and changes in the stock price will have no impact on the option value. It is so far out-of-the-money it’s likely worthless.

Theta

The amount an option price decays when 1 day elapses

A key observation which harkens back to the path-dependance demonstration:

Greeks, ie option sensitivities, are a single snapshot in time.

They change if any of the inputs change — volatility, time to expiry, interest rates/divs, or moneyness (ie the distance of the stock price from the strike price).

This is important because when we place a pair trade (long one option and short another on different names) we initialize it by trying to do it in a vega or theta neutral way. We aren’t trying to make a statement about the general implied vol, but the relationship of the implied vols to one another.

Getting back to the reader’s question…do we initialize neutrality with vega or theta?

The answer depends on what you are trying to capture when you bet on the relationship of the implied vols.

What is it about the relationship that you are trying to make a statement about?

  • Do you believe the implied vols should trade at a certain spread to each other?

    For example, stock A’s implied volatility is typically 5 points higher than stock B, but they are both trading for the same volatility so you want to buy a straddle on A and short a straddle on B. How do you weight that trade?

  • Do you believe the implied vols should trade at a certain ratio to each other?

    For example, you believe stock A should trade at a 50% higher volatility then stock B. If both are trading for 10% volatility, you want to buy straddles on A and short straddles on B. How do you size those trades?

There can be a world of difference between a spread vs ratio relationship.

If stock A is 20% volatility and stock B is 10% volatility the ratio is 2 and spread is 10 points.

If both volatilities double then the ratio is constant but the spread is now 20 points!

If you weighted the trade to bet on the ratio your p/l is 0. If you weighted the trade assuming the spread would stay fixed, your pair trade is now spitting off a bunch of p/l.

The easiest way to build intuition for this is a toy example.

Consider 2 stocks, HighVol and LowVol. They are both $100 and we are going to initiate a pair trade in a 6-month options.

I used an option calculator to compute the greeks for the 2 names:

Observations

  1. Regardless of the volatility, the options on each name have the same vega.
  2. HighVol options, which are twice the volatility of LowVol, have twice the theta and half the gamma.

    Intuition:

    theta: An option that has 2x the volatility, all else equal, is worth 2x the premium of the lower vol option. It has 2x the amount of theta to decay to zero.

    gamma: A $1 move is twice as significant to LowVol than HighVol. Just like a 1% move in SPY is more meaningful than a 1% move in TSLA.

    Higher implied vols mean bigger thetas and smaller gammas

P/L under both weighting schemes if volatility doubles

Vega-weighting

If you vega-weight the pair trade you will trade the same amount of options in each name. Why?

If you short 100 contracts of HighVol your net vega will be -2810.

-100 x .281 x 100 share multiplier

If you buy 100 contracts of LowVol your net vega will be +2820

+100 x .282 x 100 share multiplier

Net vega = -2810 + 2820 = 10 which rounds to zero. If the vol in both names goes up by 1 point you make $10 which is 1/10 of a penny on 100 option contracts. Less than the commission. Mark it zero.

We’ll just round the vega positions to long and short 2800 for the 2 legs of the trade.

What happens when vol doubles?

Notice that vega per option doesn’t really change. Computing the p/l is straight forward.

Your long option position in LowVol increased by 15 vol points (15% to 30%).

P/L on long options = 15 points x 2800 = $42,000

P/L on short options = 30 points x -2800 = -$84,000

Total p/l for pairs trade = -$42,000

If you vega-weight a trade, you are exposed to the spread! The ratio stayed the same but you experienced p/l. This weighting was not a bet on the ratio!

 

Theta-weighting

Let’s buy LowVol and short HighVol again but this time weight the legs by theta. Remember, LowVol has half the theta as HighVol so to be theta-neutral we must buy 2x as many options in LowVol.

Let’s buy 200 options in LowVol vs shorting 100 option in HighVol.

We are theta-neutral, but what’s our net vega?

Vega in LowVol = 200 contracts x .28 x 100 multiplier = 5,600 vega

Vega in HighVol = 100 contracts x -.28 x 100 multiplier = -2,800 vega

Net vega = +2,800

A theta-neutral weighting means we are long vol.

Once again let’s shock the vol but keep the ratio constant.

If LowVol goes from 15% to 30% we make 15 vol points x 5,600 = $84,000

This perfectly offsets the $84,000 loss we’ll experience when we ride a short 2,800 vega position in HighVol up 30 points as vol doubles form 30% to 60%.

Theta weighting neutralizes our position to the ratio, but it is exposed to the spread!

 

Consolidating what we know

If we balance thetas:

  • our positions will have a net vega
  • we are hedged against the ratio of the vols but not the spread

If we balance vegas:

  • our positions will have a net theta
  • we are hedged against the spread but not the ratio of the vols

 

How would I weight an option pair trade?

I generally look at trades as ratios. Why?

Because they are not level-dependent.

If the absolute level of vol is in a tight range then the spread will be stable. For example if you trade WTI crude options against Brent crude the vols are similar. If you buy 5,000 vega in WTI at 29 vol and hedge by shorting 5,000 vega in Brent at 30 vol you are vega-weighting the pair. And that will suffice for small changes in volatility. The ratio will move around a bit, but for the most part the vol spread will be pretty fixed and you’re roughly hedged so long as that’s true.

But over wide changes in volatility, the ratio is more likely to hold. If there are 2 names that are 10% and 20% vol respectively and vol roofs, I don’t expect that we’ll find these names trading at a 10 point spread like 60% vs 70%.

They won’t be trading 60% and 120% to keep the ratio constant either. But there will be less error in assuming that then vega-weighting as if the spread will stay constant.

Once a grenade goes off, path dependence is likely to swamp much of the error around the edges as you will see your vegas grow and shrink as the spot moves closer or further from your strikes as realized vol starts interacting with the implied vols.

Neither weighting is a panacea for “Am I fully hedged?”

You should look at the history of a relationship to see if the ratio or spread appears to govern the bungee cord between the 2 names but my default is theta-weighting which implies more trust in the ratio.

Just remember:

  • if you are betting on the ratio, use theta-weighting
  • if you are betting on the spread, use vega-weighting

The vega of ATM options

Holding DTE constant, we saw that gamma and theta depend on the vol level.

You may also have noticed that vega didn’t.

The 15%, 30%, and 60% vol options all had about the same vega. That reality is why we used an equal weight for the legs of the trade when we vega-weighted.

So what does vega depend on?

This is neat — ATM vega depends only on the spot price and DTE. We are holding DTE constant.

[Note: When I use ATM here I’m technically referring to ATF or at-the-forward but I’ll just say ATM which is more familiar to most]

So ATM vega only depends on the spot price. If you double the spot price you double the vega.

The proof of this can be seen easily from the approximation of the ATF straddle:

If I re-write that, it’s clear:

Straddle = σ x (.8 * S * √t)

Remember vega is change in option price per 1 point change in volatility.

A 1 point increase in σ changes the straddle by .8 * S * √t

Ignoring time ‘til expiry, the ATM vega is strictly a function of spot price!

If we vega-weight a pairs trade and Stock A is half the price of Stock B you will need to buy 2x as many options on A. In the examples we did above, both stocks were the same price.

Final recap

Holding DTE constant:

  • ATM vega depend only on spot price. Even if a pair has different vols, to vega weight a pairs trade simply weight by the ratio of the prices. This is a bet on the vol spread.
  • Thetas are proportional to vol levels. To theta weight a trade, weight by the ratio of the vols. This is a bet on vol ratio.

Learn more

Our minds love to betray us

We weren’t searchin’ for some pie in the sky, or summit. We were just young and restless and bored.

Bob Seger

Summer 1996. I turned down the $17/hr 6am to 4pm clerical job at the Canadian bank my mother worked for. I had done the job the prior summer. It was a good experience.

But scarcity mindset works on experience and not just money. The end of HS was the end of youth. I would have plenty of time later for getting “good experiences”.

I didn’t want to spend my last months before heading out for college riding a bus 50-90 minutes depending on traffic to Port Authority from central NJ, to walk 17 blocks to the cubicle farm in my ill-fitting suit heat sealed to my body by the mix of humidity and manhole vapor exhaled by the dragon known as Midtown in July.

Instead, for $5.15 an hour I operated rides at Keansburg Amusement Park 10 minutes from my house. This was a summer of degeneracy. The summer of Clerks and Dazed & Confused on repeat.

I’d work from noon to about 11pm 6 days a week. Of course only if the daily surf report dial-in lamented that it was another day of “no decent rideable ways man” in characteristic beach hobo twang. The rides in the park were the misfit toys and the employees were well-matched. I was the most responsible kid. Which is not comforting when you consider that I’d be drinking Zima (the clear color is plausible deniability-as-a-service) while egging on each side of the Pirate Ship riders to chant “less filling” & “tastes great” at the peak of the pendulum arc.

That summer’s rap sheet was a damn shame. A boy from Brooklyn drowned in the water park, the kiddie train flipped over (my friend who was operating that would die of an overdose a decade later), and one of the roller coaster carts ripped through the brake at the end of its ride, smashing into the cart that had just been loaded and was starting its ascent, injuring several riders. (Earlier in the summer I literally saved this from happening by using metal rod to trigger the magnetic mechanism that failed moments before the car came back to the platform. It’s hard to overstate how f’ng crazy this place was. Action Park got a documentary made but NJ had other contenders).

On the weekends, the live bands at the bar across the street provided the background music to an unrelenting sublayer of decay that the park desperately tried to lipstick over. The walk to the car at the end of your shift was Let’s Make A Low-Life Deal. Door #1 drunks wrestling on the pavement, door #2 an old lady shooting up like it was the 18th Street BART station. The prize door was your car intact when you arrived.

Now if my mother is reading this, it’s best to turn away now.

This is the Wildcat roller coaster:

 

This is a video of riding the Wildcat:

My esteemed colleagues and I noticed that the 300+ pound Samoan mechanic would grease the rails of the Wildcat nightly — by crouching down on the back bumper to spray the track as the coaster did its run!

Being invincible, me and the staff figured how dangerous could this thing be if Tuki (I can’t remember his name but it was something like that) could surf this sucker. We were already in the habit of riding the coaster ourselves as the park was closing when there were no customers around. Bored and emboldened, it seemed like the only logical thing to do was start riding the coaster standing up with the lap bar open. Count on the Wildcat to be able to go with the lap bars disengaged. As Axl once squealed “you’re in the 90s baby, you’re gonna die”…We leaned into that wind years before Rose from Titanic would make the pose famous.

I’m relieved to report that this behavior persisted all summer without incident.

Fast forward to today. I can still enjoy a rollercoaster.

But not a ferris wheel.

I can fly but I can’t do one of those treetop adventure parks. Other things I won’t do now:

  • Climbing the steps of the Aztec pyramids outside Mexcio City
  • Gondolas or ski lifts
  • Driving mountainside or cliffside even on the PCH

In my 20s and 30s I did on ziplines in Costa Rica, a hanglider in Rio, a microlight over Victoria Valls in Zambia.

Today, I can’t believe the person who did those things are me. I am stricken with anxiety even thinking about it. I don’t know when it started exactly but all signs point to after having kids. I can’t even watch the boys go near railings.

I haven’t sought any help because the fear isn’t impeding anything I commonly do or want to do. I didn’t grow up skiing. I hate the cold. I don’t drive fast and I don’t chase adrenaline. A loopty loop coaster or performing on stage at the music school is enough anxiety for me.

But the infiltration of this anxiety is provocative in light of a few things I’ve recently come across.

  1. Nate Bargatze discovering age comes with new surprises as well:

One thing I got when I hit my forties was claustrophobia. Never had it, actually got it here on The Simpsons Ride, which is what’s crazy. I mean, we’re 100 yards away from where my life fell apart. I rode that ride with my daughter, and we’re sitting on it, and there’s… We had another buddy, and he has his two girls on. So we sit there, and they pull the bar down, and the bar… My leg gets stuck in the middle, and it just opened a door that I never knew was there. I mean, it’s just… It is like a problem. I had to stop the ride. It’s super embarrassing to stop a child’s ride and just be like… I’m just waving, like, “I can’t do it.” Then they open the bar and go, “You can do it again.” I was like, “I’m out.” And just, no one got to ride it ’cause I couldn’t ride it. We all had to leave. Yeah, ruined it for everybody. Uh… And that’s claustrophobia, just kind of ruins everybody’s time.

It’s the… What’s funny… The panic of claustrophobia is pretty funny, though. It’s not funny when it’s happening to you, but how quick you go from normal to just an insane person, is just… It’s all at the same time. So it’s all kind of new to me, so I forget I have it, and I’ll put myself in a situation, and I go, “There it is.” I got in an Uber once with, like, seven people. We get in, I go, “I’ll get in the third row.” Try to be a good guy. I climb in the back, they put all the seats up, and it just starts hitting me. I’m back there, like… [sighs] Just trying to be normal, you know, not talking. Then you go, “Hey, you think you can roll the window down?” “You know what, can everybody just get out of the van real fast?” [chuckling] Just… We’re just driving down the interstate. “Could y’all crack the window?” “Do you mind if I drive the Uber? You think I could drive it?”

 

  1. One of my favorite posts ever by Lawrence Yeo How To Calm An Anxious Brain. The is a long and worthy read. My notes will likely be a good indicator if you want to jump in:

    Select excerpts from Lawrence Yeo’s How To Calm An Anxious Brain

  2. Jared Dillian’s Obsessive-Compulsive.

    Eye-opening. It will also halt me from casually referring to any anal behavior as OCD. Jared talks about the cause and therefore the key to the therapy is identifying the underlying source of anxiety for which the controlling behavior is a distraction from.

A few personal notes

1) I’ve started doing salt floats to see how sensory deprivation can buoyancy can help me to relax and practice emptying my head. The floating is nice if you tend to hunch over or catch your shoulders to close to your ears. That sense of self-disappointment when you catch yourself in that unengaged mid-section, sitting at a desk, creating tightness posture. I’ve done 2 sessions and will continue.

2) A close friend has a teen with severe anxiety issues. The friend has been reading a parade of books and journals as well as trying various therapies. I won’t share any specifics because the situation is a parent’s nightmare. I discovered recently that they tried clinical psychedelic treatment. The thinking was all risk-reward — the condition is as dire as possible, so despite a lack of any studies of effects on minors, it was worth a try. What’s amazing to report is that is has been the best remedy so far by a large margin. Cautiously optimistic that it will keep trending in the right direction and tempered further by the knowledge that these are long roads.

I’ll say this…my friend offered a poignant example of the difference of perception that the youth had compared to how others saw the same activity. And it was an activity that is fairly objective. The example highlighted to him just how different our internal experience of the world is. And his medical goose chase has taught him just how little we actually understand about what goes on within us.

But what did recur was this idea of unconstructive self-talk loops. It was very reminiscent of The Virus With No Vaccine, where I wrote:

There are constructs that do not exist in the world, but come into being because of language’s abstraction. For example, the idea of “worthiness”. A person may deem themselves “unworthy” replete with all the baggage imbued by the word. They identify with a word hung on them when they are young and for arbitrary reasons — a message their parent announced or simply implied. Of course the child is not unworthy anymore that it is a dolphin. Yet the word “unworthy” can initiate a stubborn thought-loop without a ctrl-break option.

By inhibiting language, the loop can dissolve. You are freed to have another thought.

It also ties in closely with Lawrence’s post. Consider these excerpts:

  • The thing about the ACG is that if left unregulated, it has the tendency to spin around wildly, When this happens, emotionally-charged thoughts get caught in this constant loop …This is a prominent feature of people with Generalized Anxiety Disorder, where intense and destructive worry can result from unreasonable thoughts. For example, let’s say you were at work and you emailed a document to your boss that contained a minor error. The reasonable response would be to simply dismiss that error as a minor one and go about your day. However, for someone with intense generalized anxiety, he could think that the error would be a sign of his gross incompetence, leading his boss to fire him, leaving him without a means to support his family, which will ultimately end in destitution and eventual homelessness. As implausible as this sounds, this negative thought can continue to loop around and grow, causing deeply unpleasant cycles of worry and fear that just won’t go away.
  • Whenever your mind is wandering for no particular reason (scrolling through your social media feeds, daydreaming about a past event, etc.), your default-mode network is active; conversely, when you’re using attention to focus on external goal-oriented tasks, neural activity in the DMN slows down, which helps to induce those beloved experiences of flow states. Although much of the DMN is located in the Land of the Wise, it’s an area that isn’t very insightful a lot of the time. Studies have shown that a wandering mind is largely an unhappy one, and tends to focus obsessively on thoughts about oneself and his relationship with others. The wandering mind tends to conjure up thoughts about one’s past, one’s social standing in relation to others, reflections about one’s emotional status, visions of an imagined future, and all kinds of shit about the past and future. To put it simply, the DMN is the neurobiological epicenter for one’s sense of “self.”

    When we are absorbed in mindless thought and are not aware of the states of our minds, the DMN is fully active and our sense of self is in full force. While feeling like you have a “self” and a distinct ego can seem comforting, the reality is that much of humanity’s problems come from the belief that we are the conscious authors of our lives. The feelings of anxiety and fear are no exception to this. Anxiety largely stems from an over-identification with the sense of self. Social anxiety’s roots lie in the erroneous beliefs of how others are perceiving your “self,” and generalized anxiety stems from worries about situations that can impact the well-being of your “self.”

    It is through the constant belief in one’s distinct selfhood that we can fail to see our lives for what they really are: continuously changing pieces of the present moment.

  • discomforting physiological sensations can be observed for what they are: patterns of energy that ultimately have no real meaning.

    There’s a well-known quote attributed to Seneca that reads, “We often suffer more in imagination than in reality.”

    Anxiety is the physical and emotional embodiment of that statement, and arises due to an unceremonious union of physiological sensations and erroneous beliefs. Concerns about a misinterpreted past and worries about an imagined future are the kindling for anxiety, and being aware of this can put out the proverbial fire before it even has the chance to start.

    As we go on, living our lives in a world full of incessant change, it will be tempting for each successive generation to wonder if theirs is the defining era of fear and anxiety.

Take care. Give yourself some grace. Don’t think too much. The poison is in the dose.