The grammar of trading

Moontower Munchies #74

Friends,

Equity markets have been crazy. In my caveman view, we just left a world where volatility markets were searching for vol buyers. The “job to be done” in options was to find a way to accumulate options without bleeding out. Selling had become too popular.

At this moment, I suspect risk groups of discretionary capital have put yellow police tape on the option sell button. The market is now bidding for sellers so that’s probably the side that offers compensation. Do this at your own risk of course, shorting vol or anything for that matter is hard because it’s hard to time but also because it has diabolical math — if you’re wrong your losing position becomes bigger while your equity shrinks (when longs lose money the losing position becomes a smaller percent of your equity). Managing trades is often harder than knowing the good side.

In any case, here are 2 good discussions of what just happened:

The (equity) volatility machine is down (4 min read)
Alexander Campbell

🎙️Solving The Mystery Of The Market Sell-Off (Odd Lots podcast)

Description
The S&P 500 has plunged more than 5% over the past couple of trading days. The Nasdaq 100 is down 7%. The Nikkei fell an astonishing 13% on Monday and then triggered a circuit breaker as it climbed up 10% on Tuesday. Meanwhile, measures of equity market volatility like the VIX have soared to their highest levels since the pandemic crisis of 2020. So what’s behind all these dramatic moves? There’s a long list of culprits, with market participants blaming everything from the Federal Reserve being behind the curve, to the deteriorating labor market and softer-than-expected payrolls data on Friday, as well as the unwinding of the yen carry trade, the bursting of the AI bubble, and the reversal of short-volatility trades. In this emergency episode of Lots More, we speak to Charlie McElligott, cross-asset macro strategist at Nomura, about what caused the selloff and how long it might last.

There are some highly interesting framing here:

“When you say that, like, stuff was already getting a little hairy last like, what were those early signs? Was it just Wednesday during the Fed decision? What were you starting to see?”

Charlie: Well, there's different time horizons for sure. And I think one of the things that we absolutely have to discuss is the signal from skew. Skew is this relative measure of demand for downside versus demand for upside…but without a doubt, when you began to see skew relentlessly, stay bid. When you began to see the volatility of volatility, stay so bid, even as stocks were trying to stabilize.

[Kris: Charlie’s point is a real-time example of how options include intel that you can’t find in stock prices. It was the point of last week’s Munchies Option Analytics For All]

He links the behavior of option skew to macro. He suggests that the tightening response to the Covid stimulus then fiscally-driven inflation led to investors reducing their exposure to risk assets. In such an environment, put skew flattened and the call skew popped as investors responded to the Fed’s hawkishness by reaching for calls to maintain reasonable upside participation.

So the last two years, kind of prior to the last six months, we were in this super bizarre place to a lot of people, with positive spot/vol correlation. Vol was going higher as the market was rallying because people didn't have the exposure and were being forced to chase.

Data was beginning to soften. Inflation was starting to come off. The Fed was kind of opening the door to the end of the tightening cycle, and you were under positioned, so you're grabbing into calls, and that same positive spot vol correlation on sell-offs meant that vol would grind lower, because you are in this really virtuous backdrop for vol selling, right? So down days were opportunities to sell vol.

And at the core of everything that has kind of happened over the last week, in particular, last few days has been about that kind of come-to-Jesus moment for the short vol trade of the past two years.

You had this dynamic where flat skew was a feature of quantitative tightening, and at the March kind of extremes, we started beginning to see skew steepen again, pretty impulsively. And that was the signal that, you know, we were going to resume back to this prior world of a negative spot vault correlation.

Terrific line here:

Volatility is the exposure toggle in modern market structure,

Charlie continues:

…that being the case, sustained periods of low volatility, where I would say that, the big shift, from a macro catalyst that occurred over the past few weeks was back to this idea that we had been consensually and comfortably in a low vol narrative, as the market was forced into a soft landing consensus last year, right? People were… fighting, fighting, fighting for the recession that never came. Ultimately, we kind of got stopped into this really comfortable backdrop, soft landing.

The Fed would still be supportive. Treasury did a little work around the edges to ease financial conditions and lighten the load of the Treasury sell-off and the long-end rate volatility in the fall. That low vol backdrop was really facilitating this massive growth in the short vol stuff that's been out there, and the AUM growth.

And it's not just short vol, it’s premium income ETFs, it's VRP, it's dispersion strategies, short correlation trades. It's QIS at banks, their proliferation, especially being used by multi strategy hedge funds, which are big users of those products. All of that stuff created the short vol supply.

And here's kind of the kicker to me, with regards to that soft landing outcome, which was consensual. We had had a kind of assigned a zero delta of a hard landing. But we had been saying for quite a long time, market had been fixated this mark. This economy goes as far as the consumer goes, and the consumer is a function of the employment data. And when in, you know, less than a month span, we've seen six of the last seven major US labor releases at magnitude downside surprises. You kind of got the whites of the eyes of this trade where, well, holy moly, like, maybe that's not a zero delta.

Digging more into the options as drivers of the stress:

We've been conditioned to see these opportunities to monetize downside hedges, or say, VIX, upside convexity in this span of hours…You have, like, a couple of hours max to monetize those hedges before reflexive vol sellers reappear, before the dip buyers reappear.

A lot of people ended the day Friday thinking that they could be short vol, and maybe short delta, because the vol moves were so magnificent. The issue then became that they got their fingers blown off on the Monday reopen. You can lose money trying to do that based on prior backtests on these vol squeezes when Asia crashes overnight, But when Asia crashed overnight, those people woke up and there was more bid for tails and VVIX (vol of vol) went absolutely bonkers.

This vol squeeze, this vol outperformance on a beta-adjusted basis was unlike anything we'd seen, I'm telling you. Like past covid extremes, past Volmageddon or LTCM. Some of these metrics were unbelievable, whether it was VIX relative to SPX, whether it was VVIX relative to VIX, whether it was skew relative to at-the-money vols. All these different metrics, 100th percentile.

This was a vol event.

Charlie goes on to talk about the role of macro which he thinks is secondary to the vol markets in this case despite all the Japan talk. He also discusses what the relaxation of the stress looks like but is not saying it’s over. All the vol metrics he mentioned have been heavily bid going into the market closes indicating there are still large accounts (he suggests dealers) buried under short convex positions.

---

Switching gears to evergreen content now.

SIG’s Todd Simkin went on Ted Siedes’ Capital Allocators podcast recently. I’m biased but Todd’s interviews are some of the best you’ll find in finance (also SIG interviews are rare to come by). Come for the discussions of risk and trader education, stay because his personal stories are highly thought-provoking.

My notes on his prior interviews are some of my most-read podcast summaries.

Notes From SIG’s Todd Simkin (35 min read)

5 Takeaways From Todd Simkin on The AlphaMind Podcast (11 min read)

I didn’t do a full breakdown of this one but I’ll point you to a few key parts.

Ted asks, “When someone's learning and getting up the curve, what are some of those most important questions that a more senior trader might ask someone that they need time to learn to ask themself?”

If I had a script for it, it'd be easy, because then I would just give people a script to use as a checklist, like a pilot does when they're starting up their plan, or like a surgeon does when they're starting a surgery. I don't have a script, and I wish I did, because then I could hand it off to somebody.

Instead, it's more like a grammar. There are things that you know how to do grammatically that you could not describe. If I were to say to you that I have eight large red French soccer balls, you would know what I mean. It makes sense. And if I were to change the order of the adjectives, it would sound crazy to you. If I moved one adjective and I said I have “eight red French soccer large balls”, I would certainly not sound like a native speaker.

You’d have a hard time explaining what the right order is for adjectives. A lot of people have gone through and tried to describe the rules here, and it comes down to number, opinion, size, age, shape, color, origin, material and purpose, I think, is the right ordering for the way you use adjectives, and you just know that.

You know that because you're a native English speaker, you've been using the language long enough that something sound right and something sound wrong. In the same way, when junior traders talk about trades, they might point out something that just feels like it doesn't matter compared to something bigger that does. And I don't know which question to ask them a priori, I don't want to say what you need to focus on is the size of the order before the price. Or you really need to focus on where the order is coming from before you look at the underlying rhythm. There's not a simple answer to it, other than to say it definitely sounds wrong when a junior trader gets it wrong and a senior trader knows it and feels it because they know the grammar. They know what goes into making appropriate decisions for risk allocation under conditions of uncertainty.

What are the signs of a someone who will become a good trader?

I think it actually goes back to the first thing we were talking about with my desire to learn sign language. It was something that I did not have mastery of and I wanted to know it better, and it was entirely self-serving. It was just for me. Nobody else cared whether or not I learned sign language. Nobody was grading me on it.

Everybody that we're bringing in as quantitative traders is smart. They're all capable. They are all straight A students in finance or physics or computer science or whatever it might be. What differentiates the ones who end up being great from those who end up being fine are the ones who just really, really want to dig in and get it and understand it and win the game.

You'll see people that will come up after a mock trading session and say, “Okay, I understand the basic options model. I understand these adjustments that we at Susquehanna make to the basic options model. And I pulled up the formula that we use to plug into the machines that are trading our automated strategies, and it has this additional factor in it. What does that factor mean?”

The person who's digging in deep enough to pull up the mechanics in the machine to see how it's treating and see how that differs from what we're teaching them in an open outcry environment.

That person is not doing it because they're getting paid an extra X dollars to do it. They're doing because they just really want to beat the rest of the people in the room at their trade. They want to understand it well enough to know this also might matter. So there's a drive and an intrinsic curiosity and an extrinsic one.

And then the other part that I've already alluded to is that they then talk about it. So when they are curious, they don't have enough information to learn it on their own. But once they start talking about what they're curious about and where their questions are, that they are finding the appropriate resources internally, and we have plenty of them to be able to point them in the right direction. To learn more, and then when they learn more. They actually have more questions, not fewer. Those are the people that have a big impact not only on their own trading, but we get to leverage those questions and really improve, best practices across the firm.

Todd tells the story of when he was on Jeopardy and after recording(but before it aired) all Jeff Yass cared about was that Todd bet the right amount in Double Jeopardy, joking that nobody cared if he didn’t know trivia but if he bet the wrong amount he shouldn’t bother coming to work on Monday. Jeff said “Just tell me what each person had at the end of double jeopardy, and I'll tell you what the right bets, should have been going.”

Todd did indeed get it correct. He lets Ted try by setting up the problem:

Charles had 11,400. I had 10,200 and Peter had 1,600.

The other thing that's worth knowing is that without knowing the Final Jeopardy category, everybody's a favor to get it right. Figure out what you think I should bet with my 10,200.

The best decision he’s ever made:

I've got five children, and I've wanted to make sure that I have a relationship with each of them, so with each of them when they turn ten years old, I've done a one-on-one trip with just me and that child. It’s the best piece of advice I have for parents everywhere.

The best advice he ever received:

The advice was passed on to me by my eighth-grade English teacher, John Patterson. But the advice comes from Mark Twain, and it is his famous quote about travel, which is: “Travel is fatal to prejudice, bigotry and narrow mindedness, and many of our people need it sorely.”

It’s this idea that you cannot be closed-minded if you expose yourself to a broader range of people.

What life lesson have you learned that you wish you knew a lot earlier in life?

Nobody cares. [I mean this] in a really positive way. The goofy thing that you love — singing in a choral group with 130 people, maybe it’s going to be embarrassing. Nobody cares. Nobody's looking at you. Nobody notices that stain on on your tie. Nobody else is thinking about you. They are all too worried about themselves. Do what makes you happy.

Don’t miss some of the fascinating sections I didn’t cover:

• why Todd majored in deaf studies

• the art vs science in trading

• Their new insurance business and some of the most fun or interesting bespoke risks that they underwrite

• Making markets in prediction markets (they are market makers on Kalshi) and sports

• The mistakes competitors who take LP money make and the advantage of permanent capital (You will recognize the thinking of If You Make Money Every Day, You’re Not Maximizing)

• Todd won his first night on Jeopardy and lost the second night. The betting strategy for the second night was trickier. Tune in to find out how that went and also why he answered the Jeopardy question with his roomate’s name.

Stay Groovy

☮️

---

---

Need help analyzing a business, investment or career decision?

Book a call with me.

It's $500 for 60 minutes. Let's work through your problem together. If you're not satisfied, you get a refund.

Let me know what you want to discuss and I’ll give you a straight answer on whether I can be helpful before we chat.

I started doing these in early 2022 by accident via inbound inquiries from readers. So I hung out a shingle through the Substack Meetings beta. You can see how I’ve helped others:

📲Book A Meeting

---

Moontower On The Web

📡All Moontower Meta Blog Posts
👤About Me

Specific Moontower Projects

🧀MoontowerMoney
👽MoontowerQuant
🌟Affirmations and North Stars
🧠Moontower Brain-Plug In

Curations

✒️Moontower’s Favorite Posts By Others
🔖Guides To Reading I Enjoyed
🛋️Investment Blogs I Read
📚Book Ideas for Kids

Fun

🎙️Moontower Music
🍸Moontower Cocktails
🎲Moontower Boardgaming

Upgrades