Building a Book
Vol #138: July 20th, 2023
Michael Jordan nostalgia has been having a moment the last few years. Just like Toyota Landcruisers and Star Wars before it, the generations who grew up with these icons are in their prime consumption years.
They’re calling the production shots and paying up for folklore. The Last Dance and Air are on everyone’s Netflix today, but it was not too long ago that a Jordan reference was dated. College graduates looking for jobs in the two thousand teens groaned at my interview questions.
My favorite ice breaker to get the conversation started about edge and probability went something like this. “Do you play basketball; would you consider yourself any good?” (I obviously don’t, so this wouldn’t intimidate anyone.) “If you got a chance to play Michael Jordan, would you rather the game be best of 3 or a single elimination?”
Most non-traders will get the answer to that question also. When the odds are long you’ve got to go for the hail mary and mix metaphors. His Airness has edge in basketball, so dominant strategy is to force an upset fluke. Now flip the tables, and imagine yourself as the one having edge. How do you maximize that for individual, client, or shareholder value?
There are many different types of edge in financial markets, so the question will depend on which type you’re capturing. There is structural edge, where participants like brokers and market makers play a facilitation role in the ecosystem. There is temporal edge, where investors with patience and low fees can beat the majority of active managers just by sitting on their hands. Qualitative research or statistical arbitrage can also be an edge, along with many others.
The thing these all have in common however is a reliance on diversification. There is no edge in the market that suggests taking a big fat swing and betting everything on a home run. Even Kelly wasn’t that crazy. (Though there are glorious stories of when this works, or doesn’t.)
The principle is that some of your bets will work out and some won’t. 96% of equities ever listed have produced negative returns. Wealth philosopher Brian Portnoy puts it very well; “diversification means always having to say you’re sorry.” A well balanced portfolio means there’s always going to be a loser on your sheets.
This fundamental truth of stochastic endeavors means that whether investor or trader, to collect edge you need to build a book. Called such because it’s a list and record of positions, a book represents the portfolio’s potential energy. It can be as simple as cash and bonds or as complicated as leveraged mark to model derivatives. Whatever it looks like, your book is your positioning on how to capture future opportunities.
Even for the most financially-phobic, hidden below three layers of fintech, the target date fund you set and forget is a relatively actively managed set of positions. Equity ETFs are systematically rebalanced into fixed income ETFs as you grow older, which each themselves rebalance to replicate indices.
More active investors prefer to concentrate their portfolio and shoot for out-performance. Their edge in building this book comes from selection acumen rather than pure passive diversification. It’s hard to deny the success of Warren Buffet, who currently has nearly half his portfolio concentrated in AAPL. The next five positions make a cumulative total of 80%.
There are two broad approaches to building a concentrated portfolio like this. Do you approach this from an offensive perspective or a defensive perspective?
The offensive mindset is looking for the hockey stick growth. It’s building a book around probabilistic shots that are cheap. Builders are creating a bright new future. You are buying lottery tickets and hoping they pay out before you go broke. The state of nature is peaceful, full of mutual goodwill and assistance. Your upside is explosive, and the downside is a slow burn into oblivion.
The defensive perspective is assuming everything is going to fail. You rigorously select only the best investments and eek out the cash that you can. Credit risk is everywhere. There is no morality, only power and war. The upside looks like coupon payments while the downside is crash and burn.
Options strategies can be bullish and defensive, or bearish and offensive. After the covered call, the wheel is one of the most common strategies that retail investors apply. For stock pickers this is a way to add a bit of leverage and premium collection to their strategy by selling left or right tails.
Dividend champion stocks are a popular sector to apply this strategy. The idea of a dividend champion is a company that has paid continuous and even increasingly dividends for a significant period of time. This predictable distribution is a sign of a strong and well managed business.
The thinking goes that if you’re happy to own the stock, selling puts is a way to get paid to do so. (Not always.1) Once you’re long the stock, you sell calls against it and capture the up trend. In the right environment this can be lucrative. Most of the dividend champions pay 3-6% yields in cash, and you can multiply that with options premium depending on how aggressive you get.
Ultimately your options selling strategy is a very defensive edge capture - you’re a credit analyst. It’s not quite nickels in front of a steamroller, but the dollars you collect from being cute have to compensate for the intrinsic downside risk and upside foregone. Two of the most popular dividend payers (Verizon and AT&T) saw two sigma moves in the past week because of their potential liability for buried lead based pipes.
Sizing is an incredibly important question for building this portfolio. Running the wheel just on VZ - it’s gonna be a tough day. Much less so if that’s one of ten names in the book.
Active traders build a concentrated book of opportunities they have vetted. But to put these positions on, they must find a willing trading partner, and that is where the market makers collect their edge. The small premium liquidity providers charge in the form of a bid ask spread is their compensation for being open for business on whatever strike you choose.
Because they are not actively choosing their specific positions, market makers must think about book building from a slightly different perspective.
For an individual issue, a position gets crafted by streaming markets that express your opinion of fair value, with baked in biases on orderflow and current positioning. If XYZ is bleeding out carry, you need to find something to sell against it. Ideally this can be done by backing off bids and being the most aggressive offer, but sometimes markets must be crossed.
Inter-month and intra-month relationships can be exploited to craft a balanced position. Your book is not built with the objective of capturing directional swings in REITs, but to be in a position to get paid on either side of the transaction that does. With this perspective there is always something cheap (or expensive) on the board.
Perhaps more importantly than knowing when to sell or buy time spreads, is knowing which issues are going to have time spreads trading. It’s highly predictable that $SPY will trade millions of contracts today, and thus the markets are going to be appropriately tight. But who will be the first liquidity provider to size up in the issue that’s about to explode?
The holy grail of books is one where something is always popping off. Tending inactively traded issues is a process of excruciating, low liquidity decisions; whereas one busy name covers all these other scratches.
Portfolios with positions across multiple different securities lets managers take advantage of correlations. Global hedging is a way that traders can reduce their overall hedging costs by approximating every position’s S&P delta and hedging the market beta with more liquid instruments.
Dispersion trading is another technique where positions in multiple securities are traded against each other. The idea is that implied volatility of index options is not always equal to the implied volatility of their components - the index is typically lower, yay diversification! This dispersion spread varies, and savvy firms can trade the difference, buying index options to sell components or vice versa. It’s as complicated and capital intensive as it sounds.
Market making as a business also benefits from having a large and diversified portfolio. Firms with broader coverage can better compete for orderflow for two reasons. The obvious one is the economies of scale and one stop service that a single shop can provide.
But an accounting quirk means that by trading a broad book of issues, wholesalers can optimize for how they meet their obligations. Price improvement is calculated by summing up the total number of pennies that retail orders were improved, divided by the total available pennies when those orders came in.
Since not all pennies are created equal, by giving additional pennies when they’re “cheap” and collecting additional pennies when they’re “dear” a market maker can selectively give improvement where it’s most beneficial. This could mean giving an extra dime of edge to a single order on a wide market (where pricing is skittish anyways) to be able to collect a penny more on a ten lot in a stable and liquid market.
A large and well diversified book affords many opportunities to buy low and sell high. It means masking your losers with winners, and moderating your windfalls with hedging costs. The diversification of opportunities contributes to a robust business and portfolio that can withstand risks, and meet objectives.
There are also good counter-arguments against using this strategy. On the upside, selling calls limits the true unbounded upside of an equity investment, and aren’t always priced such that systematically selling them is worth it. On the downside, you’re taking a similar risk, but also potentially incurring opportunity cost compared to having just outright purchased the stock if you liked it so much.