Risk is a Double Chartreuse
Vol #161: January 11th, 2024
Risk is a double Chartreuse. Edge is paying suburban Connecticut rates for it.
The monk’s fine elixir is becoming increasingly coveted amongst the dining and liqueur cognoscenti. They have vowed to reduce their production for both environmental and religious reasons. Less but for longer. And I believe them, the order once decamped to Spain for several decades over a tax dispute.
Crimped supply means prices shoot up. Even more so when there’s a dash of fundamentalism and exclusivity. The natural laws of markets are broadly acting on Chartreuse prices, but it’s taking some time for that to trickle through the system.
A quick browse online finds lots of reasonably priced bottles, but they’re all out of stock. If they do exist, it’s either a pick up only or limit of one per customer. The internet is a great democratizer, and you’re not going to find a lot of exclusive deals online shopping for an effectively discontinued item.
Try and order a glass in a restaurant; there are two responses. A knowing glance amongst the initiated, or repeating the name three times. Unfortunately just because the waiter doesn’t know what it is, doesn’t mean their bar keep is blind.
The New York City restaurant market will be efficient. Be prepared to pay more than your entree cost. The rule of thumb that a glass of wine in a restaurant costs what a bottle does retail. Despite containing three times as many servings, this rule still holds for Chartreuse.
As you percolate out the supply chain, funny things happen. Bars get stocked, and menus have prices that reflect the cost of goods at their time of purchase. Upstate, there’s not a lot of traffic in fermented French herbs.
Market forces haven’t stamped out this “arbitrage”. The edge only exists because you’re sitting in suburbia, and the maximum size you can do is pretty well capped. Local barbers don’t have to worry about competition from overseas.
If you describe this scenario in purely financial terms, there is something trading well under fair value, and the logic says buy as much as you can. Back up the truck.
Position limit is dictated by something even more powerful than the OCC. Under the best of circumstances one glass is more than enough. And even if you brought in the rest of the Meatball Dads to take advantage of this, the orderflow would quickly dry up.
I can capture this morsel of liquid edge, because of my relatively unique situation. I place a high value, due to my preferences and knowledge of other markets, on something that is not well recognized or considered in a specific region or restaurant.
This does not make my counterparty a rube, or me sophisticated. Is there perhaps a bit more revenue that Tablao could extract out of me? Yes. But hospitality, good chorizo, and croquetas de bacalao easily have us both winning the long game. In spite of and because we’re playing different games.
Michelin rated cities are the SPX and Kospi of the fine dining world. There’s no loose change on the menu, because the demands of guests and landlords keep the books as tight as their toro rolls.
When you dine and trade in the most liquid markets, you can expect the pricing and experience to be very closely aligned. One of my pet peeves is dining reviews that complain and focus only on how the restaurant is too expensive. Daniel charges $275 for their tasting menu because that’s what diners pay for the best. Did you think you were getting a deal on caviar?
As equity options volumes have doubled over the past decade, pricing has become incredibly efficient. The most awkward story for put buyers during the 2022 bear market was how well the VIX and skew were priced. Neither SPX puts nor VIX calls paid out because vol did what it said it was going to do.
When we look at the variance risk premium (VRP) of implied volatility versus realized volatility for top tier products, there is a very slim margin. The forecasted volatility is typically within 1-2% points of what happens. Sure there are kinks and gaps, but broadly the insurance providing option writers are only getting a thin margin over what they pay out in stock movement claims. And that thin margin exists most of the time because of the magnitude of the dips when it goes the other way.
This is fantastic for strategy execution. You don’t know what implied volatility should be, and neither does Citadel. But with 15M contracts trading between the NDX/SPX/SPY/QQQ complex every day, that’s not something you have to worry about. Focus on matching your needs to what the market is pricing.
Edge shouldn’t really come into the question. It’s very unlikely that you’ll find a great deal on an SPX put spread. But if it’s part of a buffer trade that hedges your principal and lets you focus on taking your family out to tapas, remember to tip your local market maker too. That pricing is ground out every day so customers can access liquidity.
Liquidity providers talk about “collecting” edge, not “having” edge. The distinction is important. The latter implies a sharper razor or objectively better approach to trading. Dealers should only be so lucky, and must content themselves with running around collecting as many slivers of implied pricing differential as possible.
The expression picking up nickels in front of a steam roller is pejoratively used to describe a strategy of selling options only to face an eventual blow out. The edge in making trading options your business, is from building a vacuum cleaner and anti-tank suit to scoop up all those nickels and weather through the hits and adverse selection. Dealers will trade any price you give them, their risk is mostly keeping their inventory up with the movements.
Edge for the rest of us comes from being unique. You don’t have to be so unique that you invent another localized volatility model, you just need to understand where your preferences can be treated well. Getting extra (but volatile) yield from cash secured puts. Giving away upside to protect the downside.
Risk is the direction we all take when putting on a position. You can hedge away parts of it, but it only gets molded, never going away. A double chartreuse is short puts in QQQY. The price you paid is but a cherry on top, did it settle the short ribs?
The real edge is because I like it.