Preventing Price Paralysis
Vol # 68 - February 4th, 2022
Living in the Midwest meant lots of driving. Cities are much farther apart, and there’s nothing but the breadbasket of America in between.
When you want to visit family, it means pointing the wheels in the right direction and finding a library of podcasts and playlists for distraction. When the only game on deck that day is beating the Google Maps estimate (DM me for my record), there’s no worse enemy than one semi-truck trying to pass another at several clicks under the speed limit.
While mathematically those few miles per hour for a few minutes of your journey don’t add up to much, the longer you’re on the road and these mini-jammatrons compound faster than a DeFi savings account.
After several hours on the highway, you develop a sort of speed vision. Time bends in mysterious ways, and pulling off an exit ramp into a neighborhood is like looking in a funhouse mirror.
Even 70 MPH feels excruciating when you’ve been comfortably cruising at 80 MPH. Just like TSLA $850 is gut wrenching when you’ve been writing checks at $1200.
The major effect here is psychological anchoring. If I ask you how many million people live in San Francisco, your answer is going to be a lot different than if I drop the modifier. (2019 Population: 874,961.) Priming is a powerful effect, every casual court observer knows you can’t lead the witness.
Even if we can recognize this effect, it can be a debilitating bias. We all want to have the iron stomach that buys the dip and deploys fresh capital when there’s blood in the streets. The reality is that most traders tend to do the exact opposite.
When the market sells off, one of the most common reactions is for investors to buy puts. Adding this protection to their portfolio means that they can defend themselves from further drawdowns. But with options, the price of that protection is not just dependent on the relative level of the underlying stock or index, but also the demand for that premium.
When buyers clamor for downside puts, they raise the implied volatility - more demand implies a higher market expectation of future volatility. Market motion certainly creates emotion, and the resulting demand is often exaggerated compared to the relative move.
The VIX is the measure of the implied volatility of a series of options on the SPX index. It’s highly correlated with the actual index - when stocks go up implied volatility goes down, and vice versa. But when the market has a choppy down day, the VIX level often reads several points higher than this correlation predicts. Lots of people are buying puts, and they’re probably over paying.
(My colleague on Options Brew TV, Jason DeLorenzo of Ad Deum Funds has great insight into this phenomenon during a recent episode. He’s developed a methodology to measure the under and overvixing effect, and what that might mean for future market movements.)
In order to prevent price paralysis and paying up for protection, the first piece of advice I’d point to is another maxim of excessive alliteration. Proper Planning Prevents Poor Performance. Having a plan for when you get punched in the face is sage advice from Mike Tyson.
The second part of that process is putting your plan into action, and overcoming the coefficient of friction. As hard as it is to open your brokerage app on a down day, executing today is planting the seeds for tomorrow.
If something unexpected happens, or you find yourself with a losing position that’s weighing hard on you, doing something is better than doing nothing.
The sharpest options trader turned writer and prolific font of valuable volatility insight on Twitter is Kris Abdelmessih. He details the trader's gallows humor of “making a sacrifice to the delta gods.” When a position is going against you, covering a small part helps ease the pain and regain focus. (Your risk manager would probably tell you to cover half.)
None of these tricks are particularly difficult. Just like jogging is simply running for an extended period of time.
While on sabbatical in Paris, my wife and I have been (finally) devouring the TV show Ted Lasso. Appropriately it’s the story of an American football coach who is transplanted in England to coach European football. Ted’s disarming charm and wit are the keys to his success, and the Lasso method encourages his players to believe in themselves.
As a financial advisor, this resonates strongly with me. I often find while speaking to clients they know far more about the specifics of any given stock than I do. I get amazing insight into different investing techniques and approaches to the market. Just like Ted can’t play soccer, I’m not a fundamental analyst or venture capitalist - my edge is in options and volatility.
Setting up a structure, and having a plan is what a good coach can help you with. Whether you're navigating the markets or the pitch, the most consistent path to success is sticking to a plan you can believe in.