You Don’t See The Whole Picture

Overpriced Or Just Overpriced In Isolation

☀️Sunblock stock (SUN) makes 10% in sunny year. Loses 2% in rainy year.

☂️Umbrella stock (RAIN) loses 2% in sunny year. Makes 2% in rainy year.


  • The year is 50% to be sunny.
  • The risk free rate is 0

A few things to think about:

  1. SUN has a higher expected return and Sharpe than RAIN
  2. We can see the stocks have -1 correlation
  3. There is an arbitrage. You can put 50% into each stock and earn 4% in sunny years and 0% in rainy years for an EV of +2% on the portfolio

What can we expect?

The market prices of these stocks will adjust to there is no arb.

Let’s keep it simple and presume:

  1.  SUN’s price stays constant so its returns characteristics are unchanged.
  2. RAIN’s price is to be bid up so it returns only 1% in a rainy year and loses 3% in a sunny year. Note that RAIN’s expected value is now -1% per year instead of zero.
Why would the market bid that much?

Because there’s still an arb.

You could put 30% of the portfolio into SUN and 70% in RAIN and still earn 50 bps per year with NO risk (remember RFR is 0%)!

What can we generalize?
  • A low or neg correlated asset, even one with a negative expected return, can improve a portfolio.
  • Assets can look appear overpriced in isolation, yet their price is more than justifiable.

When You Don’t Understand The Price You Don’t Understand The Picture

Price is set by the buyer best equipped to underwrite the risk.

If you weren’t willing to bid RAIN up you can bet SUN would have.

This leads to 2 important warnings.

1. You must diversify

Financial theory dictates that you do not get paid for diversifiable risks. To be blunt, you are incinerating money if you don’t diversify. The SUN/RAIN example can show how you would expect to lose money in RAIN in isolation because the market is priced assuming you could buy SUN. I cover this idea more in The Diversification Imperative.

2. You might be a tourist

It’s worth asking yourself, does X look overpriced because I have the wrong perspective? You are looking at RAIN but don’t see what the SUN investor sees.

A Market-Maker Example

If X is willing to pay me a high looking price for a stock or option, what’s the probability they are selling something else to someone else such that they are happy to pay me the “high” price?

Let’s say a call overwriter sees a modest surge in implied vol and is happy to collect some extra premium. Except he’s selling calls to a Citadel market-maker who’s happy to pay the “high” price because her desk is selling index vol. In fact, they are selling index implied correlation at 110%. You might be happy selling the calls for 2% when they are usually worth 1%, but if the person buying them from you knows they are worth 3% at the time you sold them then make no mistake, you are playing a losing game.

However, if your professional edge is in deeply understanding the stock you are selling calls on, then you might be the one capturing the edge in the expensive calls. You are capturing it ultimately from the fact that index volatility is ripping higher and market makers are simply capturing the margin between the weighted option prices of the single stock in proportion to the index volatility. So you, the informed single stock manager, is making edge against the index volatility buyer who set off the chain of events.

The decomposition of the edge between you and the market maker is unclear. But the lesson is you must know where you stand in the pecking order. When a market maker is asked why they are buying Stock A for $100 they respond “because I can sell Stock Z at $110”. There’s always a relative value reason. The more you internalize the SUN/RAIN example and how correlation relates to diversification the more natural this reasoning becomes.

Another example

Let’s consider another option relative value trade.  If volatility surges in A but not in B and they are tightly correlated let’s look at how 2 different market participants might react.


The naive investor isn’t aware of what is not monitoring the universe of names. They do not think cross-sectionally. They see a surge in A and decide to sell it. It may or may not work out. It’s a risky trade with commensurate reward potential.


The sophisticated trader recognizes they can sell A and buy B whose option prices are still stale (perhaps there has been a systematic seller in B who has been price insensitive. Maybe from the same class of investor our friend “naive” came from. They don’t look at the market broadly and realize the thing they are selling is starting to “stick out” as cheap to all the sharps).

Here’s the key: the sophisticated trader will do the same trade as the naive one but by hedging the vol with B, they can do the whole package bigger than if they simply sold A naked.

The sophisticated traders are the ones who see lots of flow. They “know where everything is”. While in this example, sophisticated and naive both sold A there will be times when sophisticated is lifting naive’s offer. Sophisticated has sorted the entire market and is optimizing buys and sells cross-sectionally.

Are you the fish at the table?

Flow traders and market makers are always wondering if their counterparty is legging a portfolio that they’d like to leg themselves if they saw the whole picture.

Sometimes it’s not possible because of structural reasons. For example, the risk that banks exhaust from structured product issuance or facilitating commodity hedges for corporations originates from a relationship nobody else can access.

A bank charter means some captive audiences. But that exhaust risk is recycled through the market much like a good flows through a vertical supply chain from wholesaler to retailer, with a markup being tacked on incrementally until its sold to a Robinhood client.

The markups are not explicitly in dollars but in the currency that lubricates financial markets — risk/reward. Mathematical expectancy, like a house’s edge, is priced by its most efficient holder.

If prices are always being set by the party who most efficiently underwrites/hedges/prices the risk and you know you are not one of those parties then you should wonder…

am I being arbed?

One thought on “You Don’t See The Whole Picture

Leave a Reply