Primer #6: Prospecting Funnels
Primer #6
As promised, moontower.ai includes a primer which is being dripped 1 post a week right here on substack.
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A Broad Heuristic
Professional volatility traders look for relatively mispriced options. You can think of their trade prospecting process as a funnel.
Identify fair value
Construct a shopping list of longs and shorts
Execute the trades
Manage risk
Evaluation
It all starts with a notion of fair value. In the upcoming Implementation Unit, we will learn to infer it, but first, we must establish our vantage point.
The Scope Dependence of "Fair Value"
The definition of fair value depends on your vantage point in the market ecosystem.
Market-Makers
Market-makers are in the weeds looking to make something on the order of a penny per trade. Attributes of this type of trading:
significant technology and data capex costs
economies of scale for heavy volume (ie tiered cost structures, state-of-the-art risk management and execution)
high Sharpe ratio
limited capacity
This is a widget business more than an investing strategy. They tend to be broker-dealers and not funds with LPs.
Market-makers' definition of fair value is highly temporal. To a market-maker, a “good trade” is buying something and watching their purchase price immediately become the bid. If they are fast, it means their worst-case scenario is scratching the trade for even. On the other end of the spectrum, that would be a preposterous definition of a “good trade” to Warren Buffet who is not interested in such fleeting criteria.
Fair value is scope-dependent.
It depends on your strategy, horizon and goals.
Professional Volatility Traders
The volatility manager interested in absolute returns has a wider lens. The mandate as well as the higher cost structure requires they find opportunities that have more basis risk. They are less likely to be “ironing out the kinks” of the AAPL October skew, but more likely to be a net buyer of AAPL puts against selling QQQQ puts. There’s more meat on this bone, more time to execute, and more scalability. The downside is there is more basis and margin risk. It’s a lower signal-to-noise trade. Relative value trading is about finding good bets, but it’s not arbitrage.
Compared to the market-maker who is in the weeds, the volatility manager will look for relationships that are “looser” (for example, oil versus a Canadian stock index) but not “too loose” (natural gas vs the Nasdaq). The tightness and looseness of relationships can vary over time inviting a trader’s creativity and discretion as relationships gain or lose collective salience. Fed meetings meant less when rates were pinned to zero. FX and treasury volatility as well as their cross-correlations to stocks have varying sensitivities depending on what the market is focused on.
Divining what matters is a layer of independent judgment that sits above the funneling process.
Retail Investors
Retail and fundamental investors’ interest in options originates with a directional view of a stock or asset based on their own assessment of fair value.
1) The view could be short or long-term.
2) The view can have distributional intuition:
“This stock is worth $100 today because it’s 20% to be worth $1000 in 10 years, discounted at some risky rate”
The stock’s earnings will steadily grow at 10% per year
3) The view can be a play on a sector, country, theme, or macro factor
The key:
The directional view was formed upstream of any consideration of option prices.
This retail or fundamental investor is not using options for their own sake, as their own source of alpha, but as a more efficient expression of their view. They come to the options market with specific goals:
fine-tuned speculation
hedging
This is an inversion of the volatility trader or option market-maker’s view which starts with a notion of an option’s fair value.
💡Volatility managers’ prospecting process begins with filtering option metrics. However, this approach applies to a mere sliver of the investing world.
There is one shared perspective where both fundamental investors and volatility managers will come to the options market:
Sharing an intuitive sense that an option is mispriced.
The classic example of this is covered-call or cash-secured put sellers. Even the most naive investor is not fully price-insensitive. Nobody is willing to sell a 1-year 10% out-of-the-money call on SPY for a penny. They are looking at some dollar premium and deciding that it’s a reasonable way to “enhance yield”.
moontower.ai is geared toward the professional and retail investor who trades options for any of the familiar investing urges (speculating, hedging, or yield enhancement) but uses a volatility manager’s lens for selecting the best options to meet their goals.
Funnels
Marketers, detectives, and investors follow a process that looks like a funnel. They start with a broad view of audience, suspects, or assets respectively. As the prospects move down the funnel, criteria become increasingly strict until the decision-maker is left with a small set of candidates to target.
The professional volatility manager's funnel
Start with a bird’s eye cross-sectional view of the options world
Examine liquid volatility surfaces to infer what is normal or fair
Surfaces that “disagree” become candidates for relative value trades either against each other, hedged with liquid options or simply traded outright.
Discretion narrows the candidate list further
The timing and sizing of the trade are determined
Execution
The volatility manager, like a market-maker, is often thesis-agnostic. This is the “I didn’t wake up with an opinion, but these options look mispriced” funnel.
The directional investor funnel
Investor starts with an axe to grind — they want to hedge, speculate, or enhance yield in a specific asset based on a view
By examining liquid volatility surfaces the manager gets a sense of what is normal or fair
They examine how their asset’s metric stacks up against what’s fair
They express the view in a way that takes advantage of what’s most favorable (buying or selling options or option structures) OR decide that the market’s pricing agrees with their view, making the “point spread” unfavorable. Sometimes the best trade is to simply pass or trade the asset itself instead of the options.
The timing and sizing of the trade are determined
Execution
Conceptually, the largest difference between the volatility manager and the directional investor is that the latter “woke up with an opinion, and wants to see if and how they should trade it”.
This funnel starts narrow, cross-references the idea against consensus fair pricing, then informs a course of action.
You have completed the Conceptual Unit of the moontower.ai primer. In the Implementation Unit, you will learn how to move through the funnel.