evil empire
Moontower #261
Friends,
We just renewed our lease through August 2026. By the time it ends we will have been in our rental for 6 years. We’d extend if they let us. I have family renting next door and we took down a section of the fence between our houses so it’s like a single compound with 4 cousins and grandma all in the mix.
It’s one of those situations that we never take for granted. We’ll look back at these years with a nostalgia I can’t fathom.
However, my in-laws would rather own than rent. I’m always trying to make them feel better about the money they’re saving.
[Just to scale the numbers, we live in the equivalent of a $1mm house and pay $2,300 in rent. Property taxes here are 1.25%, insurance is .50%, and home maintenance costs are choose your own adventure but in a place that starts at $650 sq/ft to build, you can fill in the blanks.]
So I send them these so they can do their own computations:
Nick Maggiulli’s Rent vs Buy Calculator
NY Times Calculator. This one has been around for a long time and has a few more bells and whistles although Nick’s is good enough.
However, buy vs rent is far from a pure financial decision. There are other weighty considerations.
Which brings me to Khe’s new calculator which, in addition to the numbers, asks a few survey questions which get fed into a black box and spit out a score from 0-100 on whether you should buy or rent.
It only takes a few moments to do it:
Tagline: Most home ownership calculators make a big mistake - they don't account for all your preferences. We fixed this for you.
I did it with a bunch of people and for the most part the answer it gives was pretty decently calibrated to what they expected.
I scored a 29, which is a bit high, I expected more like a 20. But I think having a semi-strong desire to customize my home pulled it up against what I think were values that point towards renting.
Khe will calibrate the weights in the calculator over time as he gets more feedback. A good question to add: “How liquid is the supply of rental homes in your area?”
The main reason we’d bite the bullet and buy is because the rental market isn’t liquid. In a city this wouldn’t be a concern.
[I remember many years ago a long-time SF trader telling me that “every landlord in the Bay Area is secretly a seller” and while that’s not 100% true it’s easy to understand if you can add and own a brokerage account. He was renting one of those amazing Pac Heights mansions for a number that probably couldn't cover the taxes if they weren’t Prop 13 protected. “Rent-control for rich people” is the kind of self-own SF prides itself on.]
My in-laws scored in the 70s on the quiz. Our family arrangement is on borrowed time. Maybe I like them more than they like me?
That’s ok, I love you guys, please stay!
[If they do decide to buy, I intend to engineer my next neighbor. I’ll put out a call for applications. Must be ok with us sauntering over with a boardgame and opinions.]
Money Angle
QVR’s Benn Eifert continues to be the best translator of options to normie speak. All of his podcast interviews are full of useful knowledge about options and asset management practices.
His latest appearance on Odd Lots is no different.
I excerpt my favorite parts with my emphasis at times.
1. Buffer ETFs and the Related Structured Product History (UConn Story & Cost of Predictability)
Question: I saw a headline float by about the University of Connecticut's endowment dropping some of its hedge fund exposure in favor of buffer ETFs. What are buffer ETFs?
Benn Eifert: “So this is a big new manifestation of a relatively old popular idea. So buffer ETFs are usually pitched as sort of defined outcomes in some sense over some time period where they say, well, what you're trying, what we're trying to do is give you equity exposure, but you have protection, you have a buffer down to say 10 or 15% where you're not gonna lose money as the market goes down. And then beyond that point, you're exposed. And in order to do that, you're gonna sell an upside call, you're gonna give up some of your upside. And so what this is, it's basically just a put spread collar, which is a very standard kind of option structure where you sell a call to buy a put spread that is for many, many years and decades by far the most popular thing that a Wall Street derivative salesperson will run around trying to pitch to their clients.”
One thing I don’t get is like, why would you prefer doing that versus just buying a bunch of equities and maybe hedging in a more traditional way like buying some bonds?
Benn Eifert: “So this is exactly the right question. So the first thing that, you know, a derivatives person looks at when you look at a trade like this is, okay, what does this do to the delta, the equity exposure of your position, right? So if you buy some equities, that is a one delta—a derivatives guy would say it's just a delta one position. Market goes up a percent, you make a percent. If you trade a typical put spread collar against that, you buy a put spread, you sell a call, you're probably gonna take that one.
And so if you do that kind of a trade, you might take your one delta option down to like a 0.6—down to a 60 delta. So now you're only participating kinda 60% in the movements of the market. And if you look at how these kinds of trades perform over long periods of time, they actually act a whole lot just like having sort of 60% as much stock, right? Because ultimately they're rolling these—it’s not really like a buy-and-hold-to-maturity thing. It's like they're rolling these options to kind of maintain this kind of exposure. And if you were just to take the counterfactual, which is why don’t I just own 60% as much stock and put 40% of the rest in T-bills? Turns out your fees are way less and your performance is probably better.”
Are there institutions, you know, Tracy mentioned the University of Connecticut… are there certain types of institutions where this is in alignment with the institutional mandate?
Benn Eifert: “So there are cases when that’s to some extent true, at least with some kinds of derivative structures. So you’ll have cases where there’s like a big disbursement that has to be made at some future date and they wanna lock in for sure the fact that they can make that disbursement, but usually something more like an outright put is gonna be a better match for that. Right? 'Cause the thing about the put spread or the put spread collar is you've only got like this say 10% buffer of protection, and what if the market crashes?”
So this, if the stock falls or if the market falls 25%, which does happen, you are actually not protected against all of that.
Benn Eifert: “Yeah, exactly right. Yeah. So this stuff really doesn’t lock in defined outcomes to the downside. It just gives you kind of some buffer of protection in exchange for some upside that you’re losing.”
You touched on this earlier, but talk to us a little bit more about the commissions and the execution and whether or not you’re getting a good deal on those.
Benn Eifert: “Yeah, no. So this is a really important point. Generally, these are not always, but typically these kinds of structures exist in fairly popular, fairly liquid underlyings, right? This isn’t like micro-cap stocks, this is S&P or something. So the bid-offer spreads don’t look that wide when you look at it. But you have to keep in mind if you have a $22 billion fund that once a quarter is rolling this giant collar and everybody knows about it and knows exactly what you're gonna do and knows exactly when you're gonna do it, then obviously the market just moves right ahead of you, right? And everybody positions for this trade that you’re gonna do.”
[Moontower take: this is well-aligned with my broad view that the inputs into an option price mean they are surgical tools — they are highly levered to the specific inputs. Strategies which use them with little discernment as a blunt instrument are poorly matched to why they’re useful at all. I wouldn’t die on that hill because I can imagine a very good argument for using them in a systematic way but the details matter and my point would be that the argument would indeed need to be very good to overcome my prior. The hooker asset management world often just sees a new trick where they can hide behind “I’m giving the customer what they want, that’s capitalism” but generating demand by playing framing games is zero-sum. Of course I’m biased, every time a person who makes their money in marketing outbids an option trader for a house my pen gets saltier.]
2. Benn’s favorite blow-up story
I think possibly my favorite was Allianz’s Structured Alpha, which blew up in 2020 in March. And the reason was, you know, Allianz is a huge sort of safe conservative firm that everybody would look at and say, ‘Oh, they would never be doing something kind of crazy, right?’ Because it’s, you know, they’re very buttoned up, they’re very serious people. They own PIMCO, and so they—but they had these French kind of option traders…”
(Joe Weisenthal chuckles at "French.")
Benn Eifert: “Yeah, it’s always the French. There’s just something in the DNA.”
“And, you know, they were doing something where they would effectively, they would usually sell downside put spreads—they’d sell a put, and then they’d buy back a lower strike put. That was the main thing. They’d do a few other things, but like, think of that as the core thing they were doing. Right? And that’s kind of safe-ish, right? You’re getting some credit, you’re earning some premium, but like, you’re supposed to know how much you can lose.”
“And then—but the returns were pretty good. They actually kind of kept up with equity markets, which doesn’t really make a whole lot of sense. And it turned out the way that they were doing that was that they were just not buying back the downside put—or they were buying it back but like way, way, way lower strike than they said they were buying it back.”
Joe Weisenthal: “Oh, that sounds really bad.”
Benn Eifert: “Yeah, that was really bad. And they were doing that for years and years. And it’s actually really great—there’s a whole SEC complaint about this. You can read all the details. They had to show this to investors, what they were doing, right? Because that’s part of the business. And so they had spreadsheets with all these hardcoded cells and made-up numbers to sort of be able to lie to investors and say that they were doing what they said they were doing, when they weren’t.”
“And because that’s complicated to manage—to have all these big spreadsheets faking your returns and faking your risk and everything—they actually had a Word document with an 18-point list on how to do all of the lying for all their analysts to be able to follow. And, you know, instructions on how to not hover your mouse over a formula… because the investor might see that the number was hardcoded instead of a formula.”
“They didn’t have some sophisticated methodology for this. They literally just typed the numbers into the spreadsheet.”
Joe Weisenthal: “You don’t even need to be French to do that.”
Benn Eifert: “That’s right. You just go to cell C6 sometimes and you just overwrite the number.”
“So what happened was they sold lots of VIX calls with the front-month futures at about 25. And then the front-month VIX futures went to 85. And so they were liquidated in the middle of March in a huge catastrophic explosion that people like us were shown in an auction and everything. And they drove the relative price of VIX options and futures to twice as high as it had ever been relative to S&P, in this sort of spectacular implosion.”
“They went to zero. They lost billions and billions of dollars for teachers' pensions and all this kind of stuff in just total and utter fraud. Again, at a very big buttoned-up place.”
“And actually, one of the funny takeaways from it was, in all of the lawsuits, you know, Allianz stepped up and settled lots of lawsuits and paid investors back—you know, all this money, and it cost them many billions of dollars. And so actually, in a twisted sort of way, the logic of investing with the big safe place actually worked but it wasn’t because they managed the risk or had any idea what these guys were doing. It was just that you could sue them, and they would pay you.”
3. The History of Option Selling: Good Until It Got Popular
Benn Eifert: “So from 1990 to about 2012, they look pretty good. They kind of keep up on average with the S&P but on somewhat lower volatility with a little bit lower drawdowns.”
“Option selling looked good when nobody was doing it in size, right? Option markets were a backwater. There were funny little things that a few hedge funds did, and a few kind of people, but there were no giant pension, $200 billion pension funds doing option selling. And then those pension fund consultants started writing white papers and they started pitching to their clients' boards, and by like 2011, 2012, 2013, they started to get some traction. And you started to have, you know, giant $200 billion pension funds saying, ‘Sure, we’ll put 10% of our assets in, move it from equity into option selling.’ And that grew and grew and grew and grew and grew.”
“And what happened was you see that performance then—in kind of the out-of-sample period, if you wanna think of it that way from a back test—yeah, for BXM and PUT index, which are the benchmarks for this kind of stuff, then really deteriorated relative to S&P where they sort of had very similar risk but much less return.”
4. How to Start Using Options Carefully
Benn Eifert: “Usually the first thing that I do is I send people a thread that has a collection a lot of people contributed to on good reading material and stuff.”
“And then, you know, the next thing that I tell people is what do I think are kind of reasonably safe uses of options that if you really want to dedicate time to figuring this out, you might kind of start with, right?”
“If you want to be really thoughtful about options selling, you know, to try to generate yield over time, there's ways to do that too. But you really have to read up to understand how to think about the risk-reward of a trade that you’re doing—not just believe there's something you can do all the time because somebody told you it's a great idea.”
Money Angle For Masochists
I cleaned up a thread I wrote before NVDA reported earnings Wednesday afternoon. It conveys what I was thinking as I looked at the option surface for the Friday 2/28 expiry.
Thinking aloud as I'm looking at NVDA options before earnings.
My instincts — given the January sell off in NVDA that the stock probably has some discount in the price going into earnings. In other words, if earnings are a nothingburger I’d expect a small rally. No news is good news.
Narrator: I start by announcing my bias. Whether it’s dumb or not is irrelevant. Before you look at a price, chart, option surface you probably have an expectation of what your eyes will see. I probably had many biases. But that one was the most salient before I looked at the option surface.
continuing…
Translating into option speak -- the stock is probably going up in terms of “hit rate”.
When I look at the option market, it confirms my bias (not necessarily my reason, but I’m not sure I’ve ever known a reason for anything that wasn’t as tautological as “more buyers than sellers”).
What makes me think the market confirms my “it’s probably going higher” bias?
The downside skew for earnings is fat and the 130/135 call spread is expensive. The market communicates via prices because prices offer odds. You disagree with the market by saying “buy” or “sell”.
How does the price of a call spread tell me anything about the odds?
Start with a simple proposition.
If NVDA was 50/50 to go up or down, you'd expect a $5 wide call spread to trade for $2.50 with the stock at $232.50 which is the midpoint of the strikes.
The stock was $129.50 and the 130/135 call spread was priced around $2.20.
Hmm. Antennae is up.
The call spread has a .15 delta. Meaning if we shift the stock $3 lower from $132.5 to the current $129.50 price, I expect the call spread goes from about $2.50 to $2.05 ( a change of $3 x .15)
So the call spread looks about $.15 rich compared to coin flip pricing.
How do we contextualize how if $.15 in terms of edge?
Well, think go back for a moment and think of the 50/50 case. If the stock was at the midpoint you expect the call spread to be worth $2.50. But if it’s $.15 rich or $2.65, if you sell it what kind of odds are you getting?
You are risking $2.35 to make $2.65 or getting 1.13-1 odds. What does a bookie give on an even money bet? 110-100, right. Empires are built on less edge. $.15 is a lot of edge on a $5 wide call spread.
[Personal opinion interlude: I think this was the biggest insight SIG conveyed to us when I started in the biz. Markets were wide when I was in training and you could get that kind of edge on benign things like call spread. SIG had a reputation for trading big. Using their capital, we were told to get as many lots as we could on every trade. You’re job was to fight for large allocations or splits. The edge compared to the risk on these things was much larger than the edge they saw gambling operations compound on so they optimized for market share. Many less-capitalized firms wanted to maximize edge per trade, which meant they were reluctant to tighten for market share, which can be the right move if you’re undercapitalized.
We were trained to be pigs because they understood that the getting was way too good to last so you want to maximize p/l, area under the curve. So you often pissed everyone off. Our nickname on the floor was “evil empire”*. When you start out you’re reassured “oh, it’s because we wear the black smocks”. But you learn that it’s because we acted like Amazon in a world that still had lots of indie bookstores. You can level whatever you want against Amazon, and they’ll just say “it’s better for the consumer”. Of course what they also mean is — “scoreboard”.
E-commerce and trading are bloodsports. As you learn in trading, in 5 years, you’d kick a grandma down the stairs for the thin margins you’re complaining about today. If you’re young and reading this, the cycle I’m describing is evergreen. There is someone willing to physically fight for your job if you are in a seat with an edge. That you don’t see a fist swinging at you doesn’t mean you’re not in a conflict. The zero-sumness of prop trading is the animating force behind its evolution. If that sounds rough perhaps you’d prefer a career in asset management where “solutions” can be customized to a client’s frontier. Also, if what I’m describing makes no sense to you or sounds dramatic…you’re not in trading.]
Back to the NVDA call spread…
What was my thinking and what did I do?
I didn’t trade it.
I did not sell the call spread that looked expensive. The vol lens said it was expensive, but the prior I had, “the stock is probably going a bit higher” was baked into the option market. If my prior no news is bad news, then I would have sold them.
[Note that the prior is playing a real role here and it was based on vibes. This is a complicated matter. On the one hand, I know why I give weights to my prior. It’s an old habit, that was justified. Was.
In a trading seat, you ingest a lot of unstructured flow data. Which brokers bid or offered a particular option in size? Maybe they passed. Maybe they checked another strike. Why that one? How aggressive were they, have I seen the signature of this flow before? You’re always playing this little deduction game and its output becomes the priors that influence positioning.
Today, I don’t get the same context. It makes me more hesitant. It makes me give more weight to implied odds versus my prior. In fact, with a liquid name like NVDA there is so much electronic flow that perhaps the option surface odds simply reflect a risk premium. Maybe I shouldn’t read too much into the implied odds of earnings call spread and just accept it as the price to clear a flow imbalance as opposed to anything deserving predictive weight.]
Finally, I believe the contrarian trade is probably to spec some way topside call or call spread because that's the most discounted part of earnings. Probably for good reason, but that also means it’s the more “destabilizing” move. You only get nitroglycerine if everyone is offsides.
The main lesson:
Unlike myself, many of you have stronger conviction stock opinions, so I hope marrying it with what the options market is offering allows you to better pinpoint how you should express them.
🔗Further reading to that ends
*Like these guys, I’m an Empire enjoyerrrrr
So much so that I wore a Queensryche shirt when Matt had me on his show.
But I also couldn’t decide which old school empire reference to use so you get my other favorite:
Honorable mention:
From My Actual Life
I did one of my least favorite chores this week.*
I went to the dentist.
The dentist thing happens 4x a year. Egregious plaque buildup due to mouth chemistry and thin gum tissue. Runs in the family. Our holiday gatherings don’t discuss politics or BTC but the latest travel water pik someone’s using or new mouth excavation tool.
I’m not using a water pik these days. Just an arsenal of floss, proxabrushes, rubber tips and the electric Oral-B. Which the dentist reminds me to hold with a light grip because the very act of brushing my teeth wears away my damn gums. Anyway, the dentist trip was fine. It’s been a few years since a deep cleaning and my gums have actually been improving since I started going 4x a year. I haven’t had any gum bleeding in several years as well so while a cleaning is never a treat, I used to dread the cleanings when I was going only 2x per year.
I always think about Yglesias’ Dentists are bad post because like anyone with a set of eyes you can sense that it’s a bit of a racket. I have both a dentist and pediatric dentist in my family so we cross-check all the treatments and prices with them so I feel that I’m only a victim of the baseline scamminess of dentistry and mostly avoiding the upsell.
[Dentist and veterinary services check out as fields where you’d expect PE firms to rollup because they are cash machines mixed with information asymmetries which lend themselves to increasing margins aggressively thru upsells. My sister is a vet but since I have no pets I don’t need to cross-reference her on if I’m being scammed. One of my BILs sold his practice to PE. He used to do a fair amount pro-bono dentistry for people who couldn’t pay in his community. Guessing the new owners won’t have time for that unless it can be deducted as a virtue marketing expense].
*Actually I did 2 of my least favorite chores. I reviewed all my expenses for 2024 too. The last time I did this in great details was probably 7 or 8 years ago. Yinh refers to that weekend as “The Audit”. It’s a giant joke in my family because I was so jarred. And it showed. It actually turned out to be a good thing, because Yinh, being more detail-oriented than I, proactively made some adjustments.
I should emphasize that it was also out of character for me to do an audit. I don’t keep track of spending or bills or frankly daily money matters stuff in any way. If our annual nut is within some general range I don’t sweat the rounding. I’m not a fancy spender in general, so splurges aren’t slippery slopes.
Choosing the “upgrade” hurts for a second for Pavlovian not rational reasons. I counted pennies more when I was younger but by the time you're older your portfolio vol probably swamps your budget if you continue to be a net saver so if your not a compulsive spender you’ll probably gain some mental health if you stop micromanaging your finances. Although, as I discovered this week, you should probably self-audit occasionally just to catch the recurring charges leeching your bank account.
Stay Groovy
☮️
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Love the Bayesian reasoning for trading the call spread.
Will move next door if a subsidy is included