Less but for Longer
Vol #130 : May 25th, 2023
For over four hundred years Carthusian monks in the foothills of the Alps have been brewing green and yellow herbal concoctions. “The elixir of long life.”
This famous liqueur has inspired its own color and has a secret more closely guarded than Pepsi or Coke. Chartreuse is the original green fairy, predating absinth by almost two centuries. Pronounced shar-trUHHz, not shar-trOOz.
The monks began selling the liqueur as a means to support their lifestyle of solitude and prayer. Like their Benedictine brethren a few valleys over at the Clos Vougeot in Burgundy, they quickly discovered they were pretty gifted in the wine and spirits trade.
As you might expect, they are also a principled bunch. They were expelled from France in 1903 over a dispute about taxes. Production picked up in Spain, and you can still find rare bottles of their “Tarragon” blend that was produced there until 1989. One ounce pours go for about $150.
Whether you mix it in a Last Word, or take it neat after dinner, once you’ve had a taste, its popularity is obvious. Savor it now though, because soon it’s going to be a lot harder to find. The “Pères Chartreux” announced earlier this year that they were going to be limiting production.
The primary reason is they want to focus on being monks. Fair enough. But there is also a preservationist element - “Making millions of cases does not make any sense in today’s environment context and will have a negative impact on the planet in the very short term.” They’re forgoing potential profits today not only to focus on their core values, but because to survive in the medium and long term they recognize difficult decisions must be made.
“We look to do less but better and for longer.” This monk could have been a risk manager. While the Pères are looking to protect both the planet and their order, the conservative trader is looking to protect capital. Good risk management is about giving up a little bit today, so that you can keep compounding year after year.
One of the most obvious ways this manifests in the options market is gap risk. Also known as jump risk, it’s typically modeled by shocking the portfolio in different directions. By stress testing scenarios where stock moves 10%, 50% or 100%, and vol gets cut in half or doubled, you get an idea of what the worst case scenarios might be.
Different tickers will require different scenarios. Not too many people are losing sleep over the risk on a +25% move in SPX, but triple digit jumps happen with some regularity in biotech stocks.
Liquidity providers portfolios are usually a jumble of long and short options across multiple different terms. To uncover hidden risks, scenario matrices are put together of what your overall dollar loss would be on a sliding scale of stock move vs. vol move. The world is never so simple as the blunt shock, but it gives a pretty good model for where the worst case scenario lies.
This is also what happens behind the scenes at your broker. For traders on portfolio margin, they require you to keep enough capital to cover your positions across all of their prescribed scenarios. Stock and equity calls go down, but puts and VIX calls go up - what’s the net effect?
Gap risk comes from short options. If you’re net long, the matrix is filled with lovely green plus signs - paid for of course by your theta bill. If you’re collecting premium, the name of the game is sitting tight and hoping things don’t move. When a shoulder tap tells you to buy that option back, there goes your chance at making money.
If you sold something at a higher implied volatility than the underlying is realizing, you should expect to make money. Even with the costs of delta hedging the gamma, short vol wins when stocks move less than expected.
One of the key assumptions is that you can delta hedge. That’s why it’s called “gap” and “jump” risk - it’s when the underlying moves before you can hedge it. Gap risk happens not because stock trickles down all day and bleeds through your short, it happens when the wonder drug gets approved and stock is up 110% on the first print of the day. You didn’t get to buy any short deltas between $5 and $10.50.
Most days you’re going to be fine. That’s why it’s attractive to whack out of the money puts and hold on to short options. But save those extra dollars for a rainy day fund, because eventually the piper is going to come and collect.
It is painful to cover gap risk, because it feels like you’re paying a bill for something that isn’t likely to happen. There’s an upfront cost with only fancy math and probabilities to justify it. But we cover gap risk not because it’s a good trade, but because it’s what keeps us trading.
Capital management is a survival game. You can’t win if you’re not playing, and you can’t play if you can’t pay. Much better to make a little bit less for a long time.
Part of this is the simple and brutal logic of compounding. We’re all familiar with the fact that it takes an 11% return to make up for a 10% loss, or a 100% return to make up for a 50% loss. Deep drawdowns create ever steeper hills to climb out of.
For professional traders, it’s also a business decision. Path dependency can be cruel here. If you’re banking on a big short strategy, what’s to say the 1 in 100 chance doesn’t happen on flip two? No matter how fat the edge is, you’ll never recover from that trade.
Volatility is a feature of markets but a bug for businesses. Paying rent gets more complicated if month over month is feast or famine. Employees start to spend more time worrying if they’ll have a job rather than doing their job. Bankers looking to buy you out want to see nice steady cash flow.
Deltas are hedged for the same reason that short nickel options are closed. I once ran a study on what the firm’s PnL would have been if we never bought or sold stock. Over the course of several years, the number was significant. Months of revenue significant. But the cold stretches were too much. Quarters and even years would have gone by bleeding money, all to make it back in one fell swoop.
Even if you could magically pay the server bills with hope, the emotional toll of that is exhausting. People love talking about how much you would have made if you bought AMZN or NFLX at its IPO, but without a lobotomy I don’t know anyone other than a founder who could hold on for that ride.
While it’s more obvious on the short side of options, even when your gap risk is all green there is maintenance to do. Every day you’re long options a little bit more juice comes out and they’re worth a little bit less. While the short side is hoping nothing happens, the clock consistently marches onwards for the long holder.
Instead of paying up a little bit today to get your worst case scenario under control, you lighten up your longs and accept a potentially smaller payout if it does move. Selling off some of that weight is dropping ballast so you can reach your goals.
How to cover your gap risk is where Picasso wets his brush. Managing risk isn’t just closing a position, it’s crafting the optimal exposure to fit within your risk constraints and also match your thesis. If you think that vol is too expensive in a pharmaceutical stock, you might keep your medium term straddles against buying short term protection. With orderflow presenting evolving opportunities and creating kinks in the term or vol structure, there’s always something cheap on the board.
For the front spreaders, buying short dated options are dollar cheap and packed with greeks. A nickel buys you a lot of gamma in something expiring tomorrow. Flattening your overnight risk is still an upfront cost, but you’ve patched together a risk-compliant position that lets you hold on one more day.
Long bag holders look at these same options and see expensive greeks. If you can sell something short term, you can quickly create meaningful subsidies to your theta bill. One of the indicators I track is exactly this - what’s the ratio of front month calls to back month puts? In SPY the 30 day call is about 15% of the 360 day put at 25 delta. Said otherwise, it only takes about 7 monthly call sales to finance a 12 month protective put.1
Individual investors can also appreciate the value of a robust and durable portfolio. We only get one shot at saving enough for retirement, so most people prefer to play it conservatively and slowly rotate their equities into bonds as they age gracefully. It’s also why options overlay strategies like hedged equity are so popular.
Less but for longer is a powerful motto. It reflects the difficult decisions to restrain ourselves today, such that our enterprises and endeavors persist. Overnight wealth is extremely rare and even less durable. It’s the preservation of capital and continuous compounding that let your nest egg or trading stack gather real weight. You’re going to need it to buy that VEP.
There are of course caveats to this, and when you’re selling the right tail, you’re giving away upside. Part of the extra juice in shorter options comes because of how many more paths the stock can take in the long term. For example you could get whipsawed in the short term, only to end up in the same place at the end.