Random Thoughts on Leitner’s Upside Digitals, Time Horizon, and WSB

Some thoughts on Jim Leitner’s interview on MacroHive:

My favorite idea from the pod: the discussion of replacing equity allocation with digital calls. He talks about buying say 5 year 100% OTM digital for 7 cents on a dollar. You should listen for his full reasoning but it rhymes with Warren Buffet’s thoughts on option pricing which is ultimately the difference between no-arb risk neutral derivs pricing and odds implied if you believe in an equity risk premium. (Alpha Architect blog)
Let me add to that.

Indulge this lazy theory as to why Leitner’s idea might be correct for a technical reason he can probably feel more than explain. Suppose we quintiled the broad market by valuation. Whatever metric, the US is in the highest partition. I would not be surprised if stock replacing your equity exposure with options would have been historically a good trade conditioned on extreme valuation. Not because you win more, but because you lose less when the markets roll over. And of course that means you can rebalance with a better hand after a drawdown. Total CAGR improves.

I’ll go a step further. Why might the market might price the vol too cheap on those OTM calls? Perhaps a very expensive market exhibits autocorrelation on longer time frames (ie monthly vs weekly returns). In other words, momentum prevails. The momentum can lead to cheap implied to realized vol ratios in the same way that a stock that rallies 1% per day for 20 straight days will have been a bargain buy at 16% implied vol.

So when Jim gets 13 to 1 on that digital, perhaps the true odds conditioned on an expensive market are 8 to 1 or 10 to 1. Again, this is a lazy musing, I would love to see if there’s any work out there on this.

This whole exercise is the upside version of Spitznagel’s point about conditioning convex trades based on valuation. The piece very much flies in the face of anti-timing arguments and it’s quite robust to how expensive the convexity actually is. See Universa’s Those Wonderful Tenbaggers (Link)
Jim’s discussion of BTC was ok but prompted a discussion with Yinh about our BTC holdings (which you can presume is small since I still fly coach):
1. Your time horizon should dictate the dashboard of metrics that informs your decision.

2. Disagreements about the “right” price are always a disagreement about time horizon. That’s what makes a market.

One of the points he made was about PayPal making it easy to buy BTC was bullish. This kind of argument is simultaneously insightful and deranged because it is reflexively Ponzi but also right. The “horizon” field is left blank and for the investor to fill in.
Jim’s book recs:
1. The Checklist Manifesto

Doctors make lots of decisions under uncertainty and Gawande’s book has many transferrable lessons to investment processes.

2. Superforecasting

Predictions should have time horizons and a confidence interval. Score yourself and over time you will improve.
Other recs:
1. Keep a journal of trades and the reasoning behind them. Your future self will thank you.

2. Open a play account where the money isn’t make or break. His is $100k. This account absorbs the trades which come from “feeling the need to do something”. For your real accounts, most of the time you should sit on your hands.

Extras

WSB gets emotional on Mad Money (5 min vid)
r/wallstreetbets
Last week I wrote Is Social Harmony The Last Collateral?. It was a post that regrettably resonated with many of you. Not to be dark (narrator: it’s dark), but this re-purposed Joker clip expresses the same message as my post but even better. Where I put “dentist”, it put “millennial”. The framing is more desperate and nihilistic than my post, but I reluctantly admit, it is probably more in touch. It shares my sense that the GFC was an even more watershed moment than it seemed at the time.
Made my first financial meme. Look how grown-up I am. (link)