translating to "option surface" language

Moontower #249

Friends,

A few things I’m reading:

1. The working draft of the scientific and pedagogical foundation of Math Academy. It’s free in pdf format if interested. I’m giving a small talk about MA at my local social club this week. A few weeks ago I published Principles of Learning Fast, a distillation from Justin’s blog posts which turned about to be popular. (I thought this would be more like a nerdy side-quest with narrow appeal but it turns out many of you were also gripped by it. I mostly stay away from culture topics and stick with things I’m interested in so I’m often surprised by what lands from the leftovers.)

   

2. The Buried: An Archaeology of the Egyptian Revolution by Peter Hessler
   
   In 2011, we booked a large family trip to Egypt (17 people!). We canceled within a few months of travel because of the Arab Spring (since everyone had already secured the time off we audibled into an amazing African safari vacation including visits to Capetown, Krueger National Park, and Zambia where I got to take a microlight flight over Victoria Falls which is would be totally out of the question for me today given the progression of my fear of heights).
   
   About 15 of us are headed to Egypt for Thanksgiving so this book is my prep. I’m only 50 pages into it and it’s fantastic. Not just the content but the writing style. Beautiful and gripping. I can see why it received the acclaim it did.
   

3. I just finished REWORK. My favorite parts are highlighted in Excerpts from Rework. They make for punchy reading and offer a lot to think about whether or not you're part of a larger org. It’s organized by the chapter titles (chapter are often just one page) and the blue toggles are the ones where I added resonant excerpts. As a reminder this summer I published a doc called The Culture of 37 Signals:
   

   the software company best known for making Basecamp, HEY, and ONCE; writing business and software books (Getting Real, REWORK, REMOTE, It Doesn't Have to Be Crazy at Work, and Shape Up); and inventing the Ruby on Rails framework.

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Money Angle

This is a useful practice:

Translate your sentiment into “option surface” language

For example, a reasonable posture right now is to be bullish…it’s also an uneasy one because it feels consensus.

Of course, consensus can be and often is right. It just won’t have a great risk/reward if it’s indeed consensus.

But that's a bit fuzzy.

Instead, let’s reframe:

1. A rally is expected therefore as it happens it's "stabilizing". Doesn't catch anyone off guard, frog slowly boils. Vol dampening.

2. A small pullback in the interim also not too crazy given how much we've rallied (broad indices up 1.5 standard devs in past 3 months)

In sum, the coin feels biased upward but left tail holds extra surprise (highly “destabilizing”) because its even more unexpected.

Translating this bullish distribution and vibe into options...

You'd want to own something like an ATM/OTM call spread and a tail put as an alternative to owning outright deltas.

[You could do enough of these option structures to maintain a long 100% position if you want.]

The question the advantage gambler would ask:

"Is the option market offering an attractive price for this posture OR is the structure more expensive than usual?"

You can get an approximate idea from looking at things like scatterplots of normalized skew vs vol.

[There’s a bit of push and pull. If the price for such a structure is historically cheap then you’d also be inclined to revise your impression of how consensus this posture actually is. By triangulating it with other measures of risk appetite (say credit spreads, bond yields) you can try to divine what the contradictions mean. For example, on Thursday, stocks and bond yields were up but gold, homebuilders, and REITs were down. That feels like a bullish economy outlook where bond yields are yelling “growth” while the reality of higher yields is weighing on both gold and real estate. But the fact that gold is weak says it’s not a reckless inflation story. BTC went up but that the deregulation energy muddies the water. Caveat: I wouldn’t conclude anything from 1 day’s price action. This is really just a demonstration of how you can look for contradictions to infer what the crowd is focused on.]

As I'm thinking about it, it makes me want to construct some canned structures that map to narrative postures like the one I described above. You can imagine a dashboard of such postures and the price for them over time.

“Long call spread, and long OTM tail puts” is my option translation of the natural language sentiment.

[See the unlocked post a deeper understanding of vertical spreads to review why a long call spread which is a bullish position is also “long skew” — when call spreads are expensive think to yourself “market thinks we’re probably going higher but this is counterbalanced by a further left magnitude in the event it goes lower”]

All this said, I haven't "looked up the price" which means wrangling data to see what the option market says about the full package but with SPY skews are all at middle of the road percentiles it’s probably average which means somewhat attractive if you think the distribution is more tilted than average.

moontower.ai: 90d SPY skews time series confirming average levels

On the role of options and investing

The nice thing about option expressions is the flexibility. The ability to customize the structure to fit your thesis. You can adjust the strikes to taste based on what you feel the distribution might be. You can select tradeoffs (perhaps you sell less OTM calls because you think "blow off top" is an underpriced scenario so you are willing to pay more up front premium). If you find the structure is cheap, expensive, or fair you can also decompose the legs to see what is driving the overall price.

To throw a bucket of ice water on people who want to have it both ways:

If you're a passive investor and you sweat the shape and moves along the way, you’re not really cut out for what buy and hold requires (it's a compensation for patience not labor).

The solution is most cases is simple — size down until you are comfortable not looking. You can expect a 25% drawdown once a decade at least.

If you spend more time thinking about the nearer term shape of returns...then options are more surgical. The outright stock price is a blunt compression of an idiosyncratic distribution into a flat 2-D number. Options are the 3-D version. Most people shouldn't care about the 3-D but if you do options are the weapon of choice.

By getting better at options thinking and "having a vol lens" you can parse what the surface says and compare that to what you think. The tighter your thinking the easier it is to map it to the options surface. Since it’s professional’s job to think tightly I they have more to gain from adopting a vol lens. (If you want to make a stronger statement you could say that not understanding the best way to express their views is at best an invitation to be outcompeted, at worst negligent.)

For the retail investor, fuzzy “I’m just along for the passive ride, I’ve outsourced my pricing to the market, and just have to decide my size” is fine. But if you want to take more control, options offer granularity which steer you to sharper thinking.

Money Angle For Masochists

Last week in the masochism section I wrote:

“As a junior trader I remember selling calls because "it'll never get there". I promise you there are many people who think like that. They don't understand vol trading.”

A reader asked:

What’s wrong with selling OOM call options if vol is too rich? If it's priced as a 1/100 event and it's closer to 1/1000...that's a good sell.

Here’s my response:

Given your assumption then I'd agree. But can you think of a scenario even with your assumption where it can still be wrong?

See this post How Much Extra Return Should You Demand For Illiquidity?

It looks superficially unrelated but at its heart is deeply related to the question. It's like adding another dimension (axis) to your reasoning. The effect of path and many permutations of cross contamination is hard to model but you’d be falling for a streetlight effect to think it doesn’t matter.

Here’s a phrase to inhale:

“options on options”

What is the option to sell another option at some point in its life worth? Where do those "option on options" exist, and how are their value distributed across cross-asset states of the world?

I understand that’s a bit abstract but I’d maintain it’s the best avenue of reflection. But I can also address the question more concretely, even if I don’t think it’s the best answer to the question.

The concrete response is:

If someone is paying as if something is 1/100 when you think its 1/1000 why do you think you’re right? How can you parse the difference between 1/100 and 1/1000 in a non-physical system? Did the odds of GME going to $50 change when someone started betting that it would?

[2 years ago I wrote about CVNA in A Socratic Dissection Of An Option Trade. The stock is up 50x in 18 months.]

There is a good reason why one of the first things option market makers learn is the only way to price a far OTM option is via another option, ideally of similar moneyness. Because as soon as someone says “I bet I can drink 20 beers in an hour” your belief about how likely that is requires a massive update.

[In nerd language — the Bayesian prior on what a tail option is worth, based on some underpowered frequentist sample, is so low confidence that any real bid renders it stale and worthless.]

Something I’ve always found amusing — market-maker firms will interview kids out of college and pose a proposition like “I’ll give you 2-1 odds that I will get more than 5 heads in 10 flips” and the kids will say they’ll take the bet. The interviewer will up it to 3-1 and instead getting suspicious, some of the kids get even more excited. This is the most un-street-smart instinct imaginable. (I’ve heard that SIG has or used to have an employee who could reliably flip heads better than chance who was born to give these interviews. Maybe a reader can verify this.)

In the physical world, buying homeowners insurance doesn’t make a fire more likely. Well, stock and option prices are not the world of physics and chemistry. If someone says something is 100-1 when you insist it’s 1000-1 then I think you just enrolled in a epistemology bug bounty exercise.

(The wickedness of trading is that you’re unlikely to ever get enough trials to find out if you are right or wrong, but since the odds are 100-1 even when you’re wrong you’ll just go about your life as if you were right when in fact you learned nothing.

The corollary is you should be restrained in what you think track records can tell you if a strategy doesn’t do a huge sample of trades. A truth so inconvenient the entire asset management industry, GPs and allocators alike, ignore it.)

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From My Actual Life

On Thursday I attended and had a chance to talk to Ricki Heicklen’s Quant Bootcamp. There's just nothing like this. It's ridiculous. Unless you get an internship at Jane St, this is the closest glimpse you are going to get to how they (and a few similar firms) think.

If you get a chance, do it.

Stay Groovy

☮️

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Moontower Weekly Recap

• the UI is gonna change

• adverse selection in the option job market

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