Dragonfly Eyes

Moontower Munchies #81

Sep 25, 2024

Friends,

Hypocrisy is overrated as a vice.

Don’t get me wrong, a homophobe politician caught in a bathroom stall with his “friend” can go crawl in traffic.

But the cost of being rigidly consistent in your worldview is much higher because it’s dried in a coat of virtue upon which edifices of horror are constructed. It’s the idealogue who twists into a moral pretzel. Better to protect the ego than consider more plausible models of the world I guess.

Hypocrisy comes with built-in birth control. It’s easier to resist because it’s harder to rationalize. Its ability to recruit is smaller because the dissonance is out in the open. It comes off as self-serving which eventually tires the audience out. Ideology, on the other hand, is seductive. It makes sense once you accept the assumptions.

We are all shaped by experience. A career in trading has been a large influence on my belief that the need for coherence drives us mad. I was a far more dogmatic thinker when I was young. It’s not that being cognitively flexible enabled a career in trading so much as the requirement to survive ripped my trust in lazily examined assumptions right out of me.

[A nice example of why trading demands curiosity, suspicion, and honesty about assumptions comes from Risk of Ruin’s critique of Taleb’s so-called “ludic fallacy” which he convincingly argues is a strawman.]

The universal quality of fear — you must respond to it. But you can choose to respond honestly at the cost of ego. The flexibility that trading teaches flows from paranoia. The fear of making a faulty assumption load-bearing.

The need for coherence also comes from fear but animates a different response. Digging your heels into some playhouse fantasy that is continuously reinforced by overfitting every action or utterance as “evidence”.

[As a matter of spotting talent in trading, you can’t rule someone in based on cognitive flexibility (or any other single quality) but clinging to ego is a red flag. Some people are institutionalized by their fear. The signs can be subtle but defensiveness is a dead giveaway.]

You can train yourself to be more flexible with a scout’s mindset. This sits at the heart of trading. Hacking together charts or tables to find abnormalities. Testing the ideas under live fire while having the right sense of proportion around what the experiments can teach you (said otherwise — neither backtesting nor “resulting” is sufficient. One of these non-dogmatisms that some find repellent. I’d urge those people to consider other jobs. On second thought, come right in, the water’s fine.)

I’m currently reading a draft of a friend’s upcoming option book. There’s an outstanding section on what I’d call prospecting. Where’s the fertile ground to look for trade ideas? It’s an underdiscussed meta topic. There’s no shortage of strategies to be pitched but how many of them originate from a game-theoretic perspective of “why am I even able to find this?”

The section echoes in my head because it’s ultimately about how to see things differently. While that isn’t a guarantee to discover, failing to do this is a guarantee you will not discover.

When transitioning from equities to commodities in the 2000s, I had to unlearn lots of principles. Some were simply mechanical — there are different arbitrage bounds in equity vs futures options. Some related to the zero sum nature of commodities vs the perpetual nature of a stock. Futures are derivative underlyings themselves in ways that an equity is not. Equity is an entry on a cap table. A commodity is both an input and an output to be stored, exhausted, mined, or grown. Measuring vols and correlations will help you relate to an asset you are learning about. But thinking by analogy has its limits. The edge cases demand first principles context. The fine print so-to-speak.

In my chat with Corey Hoffstein, I hit one of these points in reference to shifting gears from market-making to position-taking:

You mentioned to me that early in your transition into Parallax, you had a mentor who said to you, quote, do you want to optimize your p&l on a daily basis or something else? And that this question really unlocked something for you. What did this question mean to you? And how did it ultimately impact your behavior in your new seat?
This was a sort of a profound one for me. It was something I needed to hear. So the context here — I was in my first or second year at Parallax and I was trying to dial in my spot-vol correlation parameter in oil.
Without getting too far into the weeds, your spot-vol correlation parameter will have a large impact on your model deltas. So, for example, if you run a spot ball correlation parameter of say 1% or 100 or negative 100, what you're saying is every time spot goes up 1% I think vol comes in 1%, which is what I would say is that's a constant straddle regime. Like saying “When the futures move, I believe that the straddle is always around the same price [net of theta ofc]”
So stocks up is 1%, vol is down 1% — constant straddle. Now, obviously, that's a slope. And that's a very local slope. If the stock doubles, I don't think vol halves. So it's clear that that's not a constant parameter.
But I was being very locally minded. And the reason for that was I very concerned with my daily p&l, which is a bad habit I picked up from spending those couple of years as an indie market maker.
You don't want to be too dogmatic about your spot-vol correlation, because it does change. And so what the mentor was doing as he was encouraging me to zoom out and think about the expected value of the spot-vol correlation rather than overweighting it to like the recent observations.

There’s an additional lesson in this that is presumes an assumption that lives in oil that is far less coherent for stocks — the absolute price level matters. Because oil is an input that is refined it is both a raw material and source of revenue depending on its end user. That means its price is represented as a margin or cost on some CFO’s spreadsheet. Its absolute price has many dependency arrows in that spreadsheet. Dependencies that are managed by flipping switches or placing hedges. Sure if GME stock price goes up enough you can expect a shelf — but the degree of freedom here is much wider than what is managed in oil.

Option order flows are therefore more conditional on absolute prices in oil than in a stock. In fact, the price of a stock doesn’t mean much without considering its ratio to earnings.*

In practice, this means I care about underlying price levels in commodities when considering spot-vol correlation or skew in ways that I would simply ignore in equities. This calls for additional tools to look at the market from other angles.

In tomorrow’s paid post, we’re going to expand our thinking about volatility term structure to see why it’s a diamond with several facets — and most interestingly — why multiple ways of looking at it are not all correlated.

The title of this post is a tribute to Phil Tetlock’s phrase in Superforecasting (my notes):

Dragonflies have compound eyes with thousands of lenses “synthesized into vision so superb that the dragonfly can see in almost every direction simultaneously, with the clarity and precision it needs to pick off flying insects at high speed.”

Stay Groovy

☮️

*This idea harkens back to my post Markets Will Permanently Reset Higher (My Sacrifice to the Delta Gods) about the option contracts people should really want:

While being long the index outright is a blunt hedge, call options, for all their extra hassle, are still not a surgically precise hedge. The right tail we are concerned with is risk premiums shrinking. This can still happen if earnings fall while multiples expand. Imagine earnings falling by 20% and the index only dropping 10%. Multiples will have actually expanded by 12.5%. I admit this sounds unlikely. But we are talking about this as a right tail event. In that context, the forces which are driving the price of capital lower may even accelerate in a recession. The financial option you actually want to buy needs to be struck on the index multiple, not the index level.
So unless a liquid market develops for the SPX 10yr 40 P/E Strike Call, I don’t see a simple financial options hedge.

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