Friends,
I just got back from vacation and after traveling a big chunk of the summer, I’m looking forward to the steady backbeat of routine. Kids start school this week and that’s my cue to get in front of a computer and start pushing the ball forward on some projects.
For that matter, I’ll write a post, maybe for next week, about how I’m thinking about not just projects but the broader context of what I’m “doing with myself”. It’s almost a year and a half since I left the daily grind and while I’d like to say I have a clear picture of my next steps, it’s more accurate to say I’m just less confused. I had a lot of time to think this summer and I’ll share those thoughts soon enough.
Today, I’ll share a meta-thought.
Open Source Living
Trading culture is secretive. Now all secrets including trade secrets should be vaulted. Loose lips sink ships. But there’s a range of information that is insightful but not under lock-and-key that gets treated as a secret.
I’ve recently been consuming a ton of content by Jamey Stegmaier. He is the founder of tabletop game publisher Stonemaier who put out Wingspan. Jamey is a prolific sharer. His YT channel is outstanding and he talks about everything from nerdy game design topics, to life, to his business. His video A Brief History of Stonemaier Games is, to use that pedo-cringe term, “open kimono”. Even though his company is private he volunteers information that would be impossible to find. See 2021 Behind-the-Scenes Stakeholder Report for Stonemaier Games.
His transparency is alien to anyone from a secretive culture. Jamey has become an ambassador to the boardgame industry. Instead of protecting his turf (he’s not unstrategic of course — I haven’t seen him disclose his own vendors), he is blatantly thinking about growing the pie by promoting the industry. He encourages people to play and design games by boosting competitors’ games, discussing others’ game mechanics that inspire him, and even talking about games he wished he published or games he regretfully passed on.
Being transparent and vulnerable is a risk, but not without reward. If you embrace open-source living and can reasonably filter out selfish opportunists, you have a better chance, in my humble opinion, of “finding the others”. I used to tell myself that I wrote to clarify my thinking and educate. It was a big moment when I realized those were actually byproducts of what was really happening. I was “finding the others”. (It was Paul who I first heard say that. It was a lightning bolt of self-understanding. It’s also why it’s crazy to me that the most common writing advice is “write in your own voice”. This would be like life advice that started with “step1: respirate”. It’s not just obvious but easier).
Cooperation and negotiation are core requirements to get anything done. They don’t need to be warm and fuzzy, but the adversarial nature of spending your day on the phone with option brokers whose loyalties shift like the clay soil around the Hayward fault can grind down even the most extroverted trader’s enthusiasm. And I’m sure they feel the same about dealing with the short list of market-makers they need for liquidity. For all the aggravation, we wouldn’t deal if we weren’t both better off in the long run. But when I look around at other fields, or even my wife’s role on the biz dev side of finance, the dynamics are far less contentious. There’s more of a positive sum spirit.
Technology makes everything including finance more efficient. It disintermediates, improves transparency, and increases legibility. In that sense, technology, at the conceptual not necessarily specific instantiation level, is always a growing business. On the other hand, fields that are being disintermediated shrink. Survivors huddle on the lifeboats. If someone starts sneezing, throw ‘em overboard. A forward-looking firm might try to pull in a fit swimmer to help row, but most lifeboats would prefer to not take the risk and just preserve whatever rations are left for the seniority remaining. This might be totally rational and maximizing.
And that’s the problem.
If you are in an industry where pulling in the perimeter defense instead of pushing out the frontiers is the optimal play, I hope you are good at compartmentalizing. You don’t want that mentality bleeding over to the rest of your life outlook. At least I don’t.
At risk of a superficial analogy, it’s hard to watch boomers hanging on to their gerontocracy in politics without seeing a fearful cling to old ideas somehow wiped of any nostalgia (it’s hard to believe boomers were Flower children unless you think they forgot their LSD years). Every housing development they shoot down is stepping on the neck of someone trying to climb into that boat. Just log onto suburban Nextdoor if you want to eavesdrop on the debate homeowners (survivors is an increasingly fitting analogy here) have when a treading swimmer flails a desperate hand onto the side of the SS Nimby raft.
Morgan Housel likes the phrase “the grass is always greener on the side that's fertilized with bullshit.” There’s enough grift outside the highly regulated financial world to make the money game seem downright honorable in comparison (a finance friend has told me things about the art market that would earn Madoff’s respect). I’m not pollyannish about life outside trading. But this letter and its #learninpublic spirit have always been a step towards openness and sunlight. The upcoming projects and discussions will lean even harder in that direction. I’ll learn. You’ll learn. We’ll go further together that way.
Speaking of secrecy, Byrne Hobart recently published:
Understanding Jane Street (25 min read)
Byrne didn’t paywall this post and it was his most-read piece ever which is saying a lot, so I don’t have to say more. Go read it.
Related post on information flow from the Moontower archive:
Twitter Reminds Me Of The Trading Pits (7 min read)
Money Angle
5 Ideas by Eric Crittenden on the Mutiny Investing Podcast (11 min read)
by Moontower
I jotted a few notes from this terrific conversation between Eric Crittenden of Standpoint and my friend Jason Buck of Mutiny.
If you read CTA (especially trend-following CTAs) decks about why trend-following works in commodities you will hear stories that sound like:taking the other side of hedgers
markets have behavioral biases like anchoring which cause futures to underreact on breakouts
These are reasonable claims. I traded commodity options for most of my career and a lot of flow is in fact constrained (ie forced and price-insensitive) due to hedging covenants attached to financing arrangements for new projects such as plants and wells. The behavioral bias argument sounds good but I’m not sure to what extent biases like that cancel out (just replace “extrapolators” for “greed” and “mean-reversioners” for “fear”).
Overall, I think commodity markets are basically zero-sum. They make sense as diversifers because they can act as an inflation hedge at times. But because inflation is diabolically hard to hedge in isolation, I’d expect futures markets to have negative expected returns after fees and taxes (note the similarity to insurance. It’s negative expected return but still makes sense as a diversified and hedge when you consider compounded returns at the portfolio level). The pre-fee/tax return is probably random depending on the term-structure.
Yet, Eric and Jason’s discussion framed the problem in a way I hadn’t thought of which is more of a risk transfer service. Since the demand to transfer risk is not static the curve shapes and positioning will be key determinants of which way the edge presents itself.
If CTA positioning is inversely correlated with physical hedger positions you’d expect positive edge. I found this provocative because one of the trades I liked to look for was actually betting against the CTAs but in an asymmetrical way. If CTA’s were all-out long coffee futures (for example the Commitment of Trader’s Report, aka COT, showed that as a percentage of open interest managed money length was in the 100th percentile) then I’d like to look for cheap put skew to buy. My reasoning was that CTAs are actually weak hands in the sense that they just follow price, so if there was a sharp reversal in the market they’d rush for the exits together. CTAs often use similar signals (breakouts or moving averages for entries and stops for exits) so they tend to have correlated flows.
Now, percentiles are risky inputs to trades. If something is in the 100th percentile today and goes up tomorrow that is the new 100th percentile. But I was betting in a risk-contrained way. Instead of shorting, I was buying puts (and again only if the skew surface presented attractive pricing…the qualitative and quantitative both need to line up, and even then an idea like this is a small edge and small part of a broader portfolio).
Here is a pertinent excerpt from the interview (bold is mine):
Jason Buck: You said three return sources, so eliminate the three return sources that you believe you have?Eric Crittenden: So, I feel like there’s capital formation markets, like stocks and bonds, which are kind of a one-way street, the risk premia is kind of a one-way street. I mean, the bulk of the risk premia is your long stocks. The futures, whether it’s metals, grains, livestock, energy, these are risk transfer markets and risk transfer markets are different than capital formation markets. I feel like risk transfer markets, you need to be symmetrical, you need to be willing to go long or short, because they’re a zero-sum game. They have term structures, so they’re factoring expectations, storage costs, cost of carry, all that stuff. And then there’s the risk-free rate of return, which used to be a great way to kind of recapture inflation, it’s not so much anymore.
[Eric continues…]
This is an important concept to me, because it goes to the point of why I do what I do, or why I think that macro trend-oriented approaches expect a positive return over time, because the futures markets are a zero-sum game or actually, a negative-sum game after you pay the brokers, and the NFA fees, and all that stuff. So, in a negative-sum game, you better have a reason for participating. For you to expect to make money, you better be adding something to that ecosystem that someone else is willing to pay for, because somebody else has to mathematically lose money in order for you to make money. So, in studying the futures markets, and I’ve been on both sides, I’ve been on the corporate hedging side, I’ve been on the professional futures trader side.I believe I understand who that somebody is, that has deep pockets, and they’re both willing and able to lose money on their future’s position. A trend-oriented philosophy that’s liquidity weighted is going to be trading opposite those people on a dollar-weighted basis through time. It does make sense that they would lose money on their hedge positions, I mean, in what world would it make sense for people who hedge, which is the same thing as buying insurance, to make money from that? It makes no sense, that would be an inverted, illogical world. So, anyone who’s providing liquidity to them should expect some form of a risk premia to flow to them. It’s just up to you to manage your risk, to survive the path traveled, and that’s what trend following is. I don’t know why that is so controversial, and more people don’t talk about it, because I couldn’t sleep at night if I didn’t truly believe that what we’re doing deserves the returns that we’re getting.
Jason Buck: CTA trend followers, or whatever, just they don’t really know how they make money. They’re like, “It’s trending, it’s behavioral, it’s clustering, it’s herd mentality, and that’s how we make money.” You’ve accurately portrayed it as these are risk-transfer services, speculators make money off of corporate hedgers. But the only thing I would push back, and I’m curious your take on this, is like you said, zero-sum game or negative-sum at the individual trade level. But when we look more holistically, those corporate hedgers are hedging their position for a reason, and it’s likely lowering their cost of capital for one of the exogenous effects. So, my question always is, is it really zero-sum or negative-sum, or is it positive-sum kind of all the way around? In a sense that the speculator can make money offering these risk transfer services that the hedgers are looking for that liquidity, and then the hedgers are also… If we look at the rest of their business, they’re hedging out a lot of their risks, which can actually improve their business over time, whether that’s cost of capital, structure, or other exogenous effects.
Eric Crittenden: Absolutely, I wish I had… You did record this, so I’m going to steal everything you just said. In the future’s market, it’s negative-sum. If you include the 50% of participants that are commercial hedgers, it’s no longer zero-sum. But most CTAs, and futures traders, and futures investors don’t even concern themselves with what’s going on outside the futures market. So, but if you pull that in and look at it, you can see, or at least it’s clear to me, we’re providing liquidity to these hedgers. They’re losing some money to us, and the more money they lose to us, the better off their business is doing, for a variety of reasons. Tighter cash flows, more predictable cash flows results in a higher stock price, typically. But you brought one up that almost no one ever talks about, and that is if they’re hedged, their cost of capital, the interest rate that they have to pay investors on their bonds is considerably lower. Oftentimes, they end up saving more money on their financing than they lose on their hedging, and they protect the business, and they make Wall Street happy at the same time, so who’s really the premium payer in that? It’s their lenders. So, by being a macro trend follower in the future space, the actual source of your profits is some bank that’s lending money to corporations that are hedging these futures. So, it’s the third and fourth order of thinking, and you can never prove any of this, which is great, because if you could prove it, then everyone would do it, and then the margins would get squeezed.More commodities stuff:
I created a Twitter list to follow commodities folk. I’ll add to it as I learn of more accounts that fit. (Twitter list)
The CME has a great tool for charting and studying the CFTC’s COT report. You will need to sign up for their free QuikStrike suite of analytics.
Last Call
The 2-Hour Cocktail Party: How to Make New Friends and Build Big Relationships with Small Gatherings
Nick Gray wrote a book about how to throw a cocktail party. I’ve read half of it so far and it’s a nice reminder that get-togethers can be much richer experiences if approached thoughtfully and with empathy for guest’s desires and concerns. I will be borrowing key ideas from it for one of the upcoming projects.A bit that resonated:
There's a concept I often cite from "Moonwalking with Einstein" around memory anchors. The more anchors you can create for a memory, the easier it is to remember. If you can split your parties into 3-4 different activities in different spaces, the party is more memorable because people have a richer more varied memory to look back on. It also has the effect of making the party feel longer. When you stand around nursing tequila sodas and picking at the food for 2 hours, the party is a quick blur. When you move through four different activities and locations in the same time period, the party feels much longer during and on reflection. Time probably flew by, but when you reflect, you are amazed at how much happened in such little time.You can check out much of the book before you buy here.
Stay groovy!
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Unreal Value. Thankyou