Playing With Distributions
Vol #143: August 24th, 2023
I’m too dumb to learn from anything but experience, and too smart to believe otherwise.
I will devour volumes of knowledge on vintages, volatility, and vortexes; but nothing comes close to the visceral experience of realized distributions. Even with a cellar full of treasures, each bottle can only pop the cork once.
My perspective has been blessed-cursed with a volatility branded framework. Coincidences are nothing but realized probabilities. I believe in the power of actuaries to price any policy you can concoct and that there’s a product to structure the various outcomes.
Now as a financial advisor, my job is to give advice. I have confidence in my knowledge of options market structure and understanding of the various different outcomes from these whacky listed derivatives that somehow fit in a typical equity brokerage account. This specialty means I know more about the mercor ergo sum1 of the bid/ask spread than mutual fund distribution, but I have become convinced about one recommendation.
Everyone needs play.
Even in trading. Play is learning made fun, and knowledge concretized by positive endorphins and proud memories. It is what keeps you engaged through the valley of despair, and motivates you up the slope of enlightenment. Being made a fool in a controlled environment is how you get to be a wise man in the face of uncertainty.
Ian Bogost is a video game designer and cultural critic who is also the author of the book “Play Anything.” He argues not for a Lumon Industries gamification of tasks, but rather for understanding that “fun is the opposite of happiness”. Concentration, and engaged struggle are what produce not a bubbly giddiness but true satisfaction and meaning.
When people get hooked on anything from Candy Crush to Wordle, they are not coming back every day because it’s easy. The hook and sense of achievement come from failing before arriving at the answer. It’s finally resolving that pesky merge error in a software rollout or nailing the buzzer beater free throw after putting in gym time every night for a month. Fun is so much more than a smile.
A good science museum is the perfect example of this. This past week with the playgrounds a broiling sea of concrete and plastic, my family opted for maximum dosage of A/C play, and the Kiewit Luminarium in Omaha, NE has a number of clever exhibits for the 2-100 crowd. If you’ve ever felt bad about the extra Runza you ate, I learned I walk about 11.5x more loudly than my daughter across a pile of crushed stones. The same one that can awaken an entire hotel at 3am and only weighs 1/6th of me.
While I was pleasantly surprised at an exhibit on the second floor on compound interest, I was gaga over the plinko like game showing distributions. A four year old could funnel a slug of shot pellet through a peg board and watch what normal realized.
This has always been my favorite analogy for distributions. With a single motion you can realize hundreds of possible outcomes. The craziest balls will bounce to the wings, or even off the board. But the vast majority settle right into the middle. Whether you’re calling random variables in the new Python/Excel collab, or measuring the height of the 4th grade class, this truth has pull across many domains.
When pricing volatility, we are talking about a measure of different possible outcomes. Every individual ball will follow its own path, but behind it there is a process launching the trajectory of these paths that can be modeled over a sufficiently large number of cases. Most of the balls land according to the bell curve. Not every turn of the board is perfect, but as n increases, the sample will approach the population.
The fact that you can kick balls out of the nice neat model framework is probably the most realistic thing about this device. Math works well on a napkin and in a spreadsheet, but it never quite captures every possible reality. The ball that jumps off the tracks is akin to the special dividend that was announced just under the threshold, or the judicial technicality that causes a merger to fall through.
When trading options professionally, you need to think in large numbers. Dealer firms trade millions of contracts per day. The way edge and inventory management works is through a whole lot of coin flips, wheel spins, and die cast. Technology, operations, and risk management play a critical supporting role, but the core business model is pretty close to trade/hedge/fade repeated as many times as you can.
Liquidity taking traders don’t usually have the law of large numbers on their side. While there is an impressive coterie of buy side sole props that can make this strategy work, for the most part customer orders must be rooted in some other kind of edge.
A trading strategy of collecting bid/ask spreads and managing realized distributions requires that you take many trades. There is a stochastic process that emits new orders and prices - also known as buyers meeting sellers - and it will continue to spit out the next one. Market makers are in the business of reacting and can only broadly pick or choose what they get. Not only does the exchange mandate your quoting requirements, and while one must be picky and deft to avoid adverse selection, to be a liquidity provider you have to take the other side.
Most other trading strategies don’t require you to do anything. It’s the itchy feeling in your prefrontal cortex doing that. A wild benefit of being a buy side customer is that you NEVER HAVE TO OPEN A TRADE. (Margin, PnL, etc may force you to close one.)
With this comes the wide open freedom to pick your spots. There’s no contra side order flow demanding your liquidity, and so while you pay the very small Six Penny Spread to get access to bids and offers on demand, an order comes only when you’re ready.
Patience is invaluable. It lets you choose to only trade when something aligns with your thesis. Playing NVDA 0.00%↑ before the earnings report is a fool’s errand (unless you’re playing at least a dozen other names too). On average, the straddles and front month options will be priced to perfection. It doesn’t match every time, but there are more ways to lose long and short than any other time.
On the other hand, taking the market's initial “voting machine” reaction and positioning yourself with all this new information in hand for the medium term “weighing machine” to follow its course can be attractive. Rather than trying to bet on how well Wall Street guesses financial benchmarks, using the released information to set up a more informed structure will lead to less sporadic results. There’s no rush to get a position right before the event happens, and the outcome may or may not result in an opportunity - that’s okay.
Customers not only have the flexibility of timing, but they also have the flexibility of sizing. You don’t have to do a ten lot or a hundred lot to get an idea of how options work, the one lot behaves exactly the same way. It sounds self evident but you don’t have to write calls against your whole position. You don’t have to use an X% trade size. If the point is play, optimizing capital shouldn’t be the consideration.
To really learn and understand the power of options, you need to make some trades and see what happens. That probably means losing money and taking some hard lessons. But if you size it right, the lessons you learn from this are invaluable.
You’ll likely learn that you have no edge in earnings trading, and hopefully the tuition was kept small. But more importantly, you’ll hopefully understand two bigger lessons.
The first is the value of a simple strategy for the vast majority of your money. An appreciation for the difficulty of active trading is only learned through experience. It’s really easy to lose money and really hard to make it - despite the brainrot on TikTok.
And further, hopefully you can start to climb up the slope of enlightenment to understand where options work for you on a bigger scale. We’re only human to think we see an obvious money making trade. Give it a (small) shot.
Taking some chances in your play account keeps you in tune with the market and helps you be a better investor. I doubt it’s in 0DTEs, as fun as all that immediate feedback is. But setting up overlays to fine tune your individual positions or ETFs becomes a lot more interesting.
When I make small trades every day in my account, I don’t expect to make money just from those opportunities, but from what I glean from always having an iron in the fire, and can apply to broader solutions.
It’s not all cash and laughter, but playing intentionally and attentively might just lead you somewhere interesting.
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This week on Trading Opportunity with TheTape we covered:
Bitcoin Bros Bounce: $BITO has taken a beating as crypto liquidity drains - is the move over?
Zooming, but not moving: Earnings beats and sideways trading while volatility remains bid in ZM
For Portfolio Design with TheTape, we talked about the relationship between interest rates and volatility:
Hoot Go the Treasuries: Options structures to capture multi-decade highs in interest rates
I trade, therefore I am