I feel lucky that Jason Buck reached out to sponsor the letter because I love what he’s doing (Yinh and I were early investors in their latest fund). In addition to managing a fund, Jason is co-host of what I think is the most underrated show on investing YouTube, Pirates of Finance.
In season 3, Jason and Corey Hoffstein changed the format so that there is zero preparation. The conversation is totally off the cuff. And it totally slaps.
It is free, buried booty that our theoretical economist says can’t exist because of efficient markets. But it exists. I’ll prove it by digging up 3 themes from their amazing recent episode Decision-Making Under Uncertainty and mix them with my own thoughts. We’re blending Moontower and Pirate rum up in here today.
Why ETFs Might Be Unsuitable For Some Strategies
ETFs are liquid structures designed to faithfully track NAVs (“net asset values”) because the arbitrage mechanism is outsourced by the issuer to an Authorized Participant. These AP’s are a subset of the market-making community.
The Pirates wonder:
Is the ETF structure, whose allure is transparency, the correct home for opaque, illiquid, or bi-lateral (ie there’s credit risk in the basket) instruments such as inflation swaps? What about semi-liquid holdings like corporate bonds or even TIPs?
The answer to such questions partially rests on the liquidity of the underlying holdings. Consider a question they allude to but I’ll make explicit:
If you hold long option or long convex positions via ETFs (or for that matter directly) will you be able to monetize them when they pay off?
This is a real and highly underrated concern. Bid/ask spreads are positively correlated with volatility. So how useful is it if the paper profit on a convex position can’t be crystallized because the bid-ask is wider than the parted Red Sea?
Suppose you buy a way OTM put option for $1. It explodes to $20 but the bid-ask is now $16-$24. Sure, you can sell it for a 16x return, but when that option was originally valued for $1, the pricing incorporated the idea that in some rare states of the world the option is worth $20. If you can never realize that $20, then you entered into a pretty negative expected value situation when you paid $1 for it in the first place.
Trading is hard enough, you can’t afford to not maximize small edges. In a separate interview Corey talks to option trader Darrin Johnson.
I paraphrase Darrin:
When you sell tails, you need to capture the entire premium. The hit ratio of selling tails is high but when you lose you lose many multiples of the premium. If you fail to collect the full premium, it will not make up for the losing trades. The difficulty of selling tails is even trickier yet.
Darrin explains how betting against longshots leaves you uncertain if you have an edge in the first place. In my words: good luck differentiating between a 50-1 shot vs a 100-1 shot. That’s the difference of 1 probability point but it’s massive in payoff space. [I discuss that idea further in Tails Explained.]
When volatility increases, transaction costs go up for everyone. Since market-makers are part of “everyone” then the cost of their own hedging (ie replication) goes up as well, so they charge wider-bid ask spreads to keep them whole. MMs represent the marginal supply of liquidity so can they pass the transaction costs of their own “COGs” to those demanding liquidity. We know the house wins both ways, but the house edge itself is correlated to what markets are doing. If the house’s margins above their “COGs” expand in times of stress, you need to haircut the expected risk mitigation from defensive positions. That cost will show up when you try to roll or monetize.
There are cases where that bookie’s vig will not be too punitive even in a volatile market. For example, if the option you buy is now so far ITM that it no longer has meaningful extrinsic value, then you can simply trade the underlying to monetize (although re-hedging will put you face-to-face with the market-makers again).
This brings us to the next theme.
Destination vs Path
If you have a view about the expected return of an asset in 5 years should you care about the path? Depends who you ask. Anyone marked-to-market (HFs, market-makers, futures traders) will say yes especially if they are managing money for others. PE, RE, and bond investors are more likely to say no. The Pirates have a nuanced discussion about whether it’s even possible to manage to path versus manage to terminal value.
I’m biased by my path-or-die experience in trading. Mark-to-market is the goddess of tomorrow, you can’t afford to piss her off.
Here are a collection of arguments that I offer her as tribute.
- Bond investors who ignore path are fooling themselves.In Why Volatility Still Matters To Buy-And-Hold Investors, I summarize one of Cliff Asness’ pet peeves:
You may hear some people say they want to buy an individual bond rather than a bond fund. They worry that bond fund prices move around and have no real expiration, so when interest rates rise your losses are somehow more real. But if you buy a bond and hold it to maturity you can put your head in the sand, and never lose.
This is nonsense.
You have lost in a real sense since the money you are being returned is worth less in a world in which rates have risen to compensate for inflation. The bond fund is effectively taking your loss today rather than later. If you sell your bond for a loss, you can reinvest at a higher yield going forward. That’s a similar experience to just being in the bond fund. Holding to maturity does not mean you have less risk. It’s an illusion. A real vs nominal illusion.
- Using stale marks to “smooth volatility”Having a preference for private assets that are less volatile simply because their marks are stale is like not getting bloodwork because you don’t want to find out your cholesterol and blood sugar are too high.
The slow-to-mark investments are still volatile. The fundamentals of the private business are correlated with the public market volatility.
Even if you don’t believe your investment should be marked down, then you should be sad you can’t redeem your private investment at par to rebalance into public stocks after the market drops 20%. Giving up liquidity without a premium because it will behaviorally “save you from yourself” sure feels like you sold the option to rebalance at zero.
I walk through that argument in How Much Extra Return Should You Demand For Illiquidity? (7 min read)
- Market prices are clever. They can balance the wagers of path vs terminal value investors simultaneously!In What The Widowmaker Can Teach Us About Trade Prospecting And Fool’s Gold, I show how the calendar spread options are priced so that the path of the gas price is highly respected, even if there’s strong consensus about the terminal value of the spread (ie the March-April futures spread which is a pure bet on in winter gas being in short supply).
The OTM calls are jacked, because if we see H gas trade $10, the straddle will go nuclear.
Why? Because it has to balance 2 opposing forces.
- It’s not clear how high the price can go in a true squeeze or shortage
- The MOST likely scenario is the price collapses back to $3 or $4.
Try to think of a strategy to trade that. Good luck.
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. The vertical spreads all point right back to that price range.
The market places very little probability density at high prices but this is very jarring to people who see the jacked call premiums.
That’s not an opportunity. It’s a sucker bet.
Another common example:
In options land, many investors like to buy 1×2 ratio spreads because the payoffs look amazing for low-probability events. For example, if a stock is $100 and you can buy the $115 call and sell 2 of the $120 calls for zero premium, you think to yourself:
a) “If the stock does nothing or goes down I break even”
b) “If the stock goes to $120, I make $5” (or $1 if the stock goes to $116)
c) “I don’t start losing money until the stock goes over $125. That’s 25% away! This is risk-free return”
Nah dog. That’s first-time-at-the-rodeo thinking.
The reason the 1×2 is so cheap is the call skew on the $120 strike is pumped up because someone has been buying them like crazy. That’s where the bodies are hidden. The question you need to ask yourself is “conditional on the stock going to $120 did it get there fast and sloppy, or slow and grindy.” If it goes there in a fast way, the market-maker community will be short beaucoup gamma and be scrambling to buy the $120 calls back. You sold some teenies and went to Santorini and are now getting a margin call on the beach because the 120s you’re short are blowing the f out.
The path-aware trader is plotting how to be long the scenario where your vacation abruptly ends.
- If path is so important, how can you manage to it?a) Avoid excessive leverage
b) Pre-determine when you will cut losses (beware this can be a big topic with lots of room for disaster)
c) If you insist on betting on terminal value, do it in fixed premium ways where your max loss is bounded. Now you don’t have to worry about mark-to-market risk.
In There’s Gold In Them Thar Tails: Part 2, I cover the topic of path, how to exploit investors’ lack of appreciation for it, and how Jon Corzine became a symbol for path-blindness.
“Long-Short Portfolios All The Way Down”
You’ve heard the expression, “turtles all the way down”.
Corey says “Long/short portfolios all the way down”.
This is an acknowledgment that every trade you make is relative to something else. If you buy a stock denominated in dollars, you are betting that the stock will outperform dollars. It’s a powerful idea. If you want to short XOM but can’t get a borrow, you can buy all the components of XLE except XOM while shorting XLE. Voila, you are now short XOM.
The pirates offer more great examples:
You start with a 60/40 portfolio and stocks go up so the new portfolio is 65/35. You can think of a regular rebalance to get you back to 60/40.
Or you can re-frame the accounting to an algebraic equivalent:
You own a 65/35 portfolio + a long 5% bonds/short 5% stock overlay
It seems like semantics, but just as different words can refer to very similar things, there remains meaning behind the distinctions. And the subtlety here is useful because it forces you to look at the accounting of subsets of a larger position. Corey argues that this lets you think about how things are contributing to your portfolio at any given time or even over time
This lens is the gateway to better p/l attribution. In the 65/35 example, the intuition is fairly basic. Rebalancing trades profit when the market mean reverts and lose money if the market trends. Gamma-scalping works the same way. It’s just rebalancing for option traders. If you trend, your “daytrading p/l” will be negative if it is dominated by gamma scalps and you’ll regret going into work that day (because you will presumably have been hedging your growing delta, for example, you sold the VWAP but the market closed on its daily high.)
I agree with Corey. Seeing the world as long/short portfolios focuses you on the relative nature of every decision! Every time you are long X, you are short [not X]. If you buy a house and it goes up in value along with every other house in your state, when you sell it, did you really make money if the neighboring cost for shelter has appreciated all around you. Start seeing your decisions as long/short portfolios and it has a funny way of focusing you on what you’re specifically rooting for.
2. Corey poses another thought exercise:
Which do you think has a higher tracking error to a passive 60/40?
a) Replacing the passive equity with small-cap value exposure
b) Layering 60% exposure to the SG CTA Index on top
I promise the discussion thread will make you smarter.
I’ll sprinkle in a related idea that comes from options land.
It’s natural for vol traders, especially dispersion traders, to think about positions as a series of long/short portfolios. That’s because all dispersion is “dirty” dispersion. [If you need a refresher see Dispersion Trading For The Uninitiated].
If you sold SPX index vol and only bought vol on value names, your net position is:
- short growth volatility
- long value volatility (you are net long, because if you tried to balance your gross index and single name greeks, you’d necessarily have to overweight the value names. This is extra true if you theta-weight the spread since the value names are lower volatility than the growth names.)
If you had this position on before Softbank started buying the hell out of tech calls in the summer of 2020, you got rocked.
But if you put that same position on right before the Covid vaccine was announced, you killed it as value names surged while growth names barely moved relative to their vols.
Index traders are keenly aware of these “synthetic risks” because at some point you’ve been unknowingly exposed to a risk factor that took a bite out of your p/l. That prompts you to slice and dice your risk to further your understanding of positions. Risk management evolves one bruise at a time. The inevitable body shots and jabs hurt, but also teach. You just have to get your overall controls robust enough to survive the haymaker.
[Speaking of teach…did you know that if a stock is halted, you can compute what price the market is implying it will open at? Just compute the price the SPX cash index would need to be at for the futures to be priced fairly to back out the halted stock’s implied price.]
Corey is spot on. It’s long/short portfolios all the way down. This is native vision for derivatives traders.
In closing, know that I’m not just shouting my friends when I say to watch Pirates. That’s seeing causality backwards. Jason is sponsoring Moontower and I met these guys in the first place because I was attracted to how they think (well that’s half of it…there are plenty of brilliant people out there I have zero interest in hanging out with. These are friends that got through the important funnels after I noticed they were smart.) I always learn when I listen to these guys. They’re entertaining and always have good stories.
Actually, you know what? F those guys. Hoggin all the cool in the room.