Throughout the north east, this has been a particularly difficult spring for pine trees. With gusts well into the 70 mph, decades of growth and shade can be swiftly eliminated.
There was a small crack, but a quick glance out the darkened windows didn’t reveal anything. Must be the neighbors. But come the light of day, there blocking the driveway, lay a seventy foot tall Norway Spruce.
Given that it was the first morning back from spring break, nothing was stopping us getting to school. I started clearing just after sunrise, and had an exit path within the hour. Later that day with just a ten inch bar chain saw, the trunk and branches were parsed into barely manageable pieces. Plenty of wood to burn.
The only lasting damage was the new roof over an old well. The trunk ripped a two foot long track right through the shingles and underlying plywood. Concrete footings were shattered in place, and the supporting posts have deep splits from the stress. But the colonial garden folly is still standing.
I built this trussed roof for a dormant stone well the summer after we moved in. It was the first step in a series of ongoing projects of escalating size. I’d learn to shingle here, so I could build a bigger shed for the firewood (ironic in hindsight); all with the goal of finishing the interior of the wine storage barn.
While couched as skill building, the well was a vanity project. It is a century past use, and had absolutely no need for a covering; let alone one with a custom “P” etched into powder coated braces.
Now my folly is a liability. There’s an obvious gash, and everything's a lot more wobbly after taking a five thousand pound hit. If I don’t repair it, now I’ve added negative value.
When the final piece of asphalt was tacked on, I thought the project was over. Yet what was a pleasing - maintenance free - sight at the foot of the driveway, now needs to be materially rebuilt. Plopping even the smallest structure on your property ticks up exposure. Ornamental or fundamental, more variables increase entropy and cost. Risk vectors hiding in plain sight.
Whether the complex system is your home or the algorithm, predictability matters. Funny behavior after this tweak or that setting leaves the user confused. Some of the best intentioned trading tools I’ve seen developed quickly fell out of use because of their complexity to maintain and unexpected outputs.
Market makers rely on scripts to automate as much of their workflow as possible. When the feed reads that stock has gone up, options prices automatically adjust. Same with time passing. As variables get more nuanced, like implied volatility, skew, or even orderflow patterns there might be varying degrees of automated movement.
Part of a dealer’s pricing equation is based on what the market is saying, and part is based on what their position is. A long or short bias based on inventory in theory would incline you to buy a little more dearly or sell cheaper if it means closing the position. Edge on both sides and a flat book is the dream.
So the Axe Matrix sounded cool, and made logical sense. There were coefficients that weighted how strongly different months and strikes should impact each other. In other words, how much of a better buyer of the Dec 200 strike are you if you’re short the Aug 190 strike?
(Did you guess this was designed and fast tracked by a risk manager yet?)
There were absolute limits, and different settings for different products. All of this was fed into a layer that munged your theoretical value against parameters to define bid and offer prices. The outputs regularly had people scratching their heads as to why they were on or off a given market.
So no one used it. Literally not a single trader.
While the principles of position management were sound, expressing that through compounded shades of bias and roundings was very difficult. Further, by dissociating the trader from the pulse of activity on the markets, they lost the information value that allows them to participate in maximum size at the best level or on the best orders. Price over position.
Whether it's an extra roof to repair, or a preference matrix to update, prettier and smarter isn’t absolutely better. If you can’t maintain something, it’s not an edge.
This lesson extends to buy side trading activity. More indicators or more position grooming might not necessarily be adding the value you want, and worse could be introducing other vectors of risk.
For active traders, a common reaction to economic events is to limit activity. The recent history of 2022 has scarred everyone about the FOMC meeting potential. One month the news in the ISM manufacturing index might spook the market, while eleven other instances are snoozers. Should I avoid or trade earnings?
If you’re backtesting or just going on a hunch, pay too much attention to the calendar and it risks overfitting and costs opportunity. The big deal events are usually obvious and can add a nice safety buffer, but too much nuance is self-defeating. You’re simply looking for good risk/reward setups, not some perfect alignment of stars.
When options strategies are used to manage portfolios, linear stock exposure gets sliced into different time buckets by expiration cycles, and PnL from one or more securities starts compounding. Rebalance timing risk is present with overlays, and tax complexity comes in with short term gains and long term losses (or vice versa, or both, or neither).
The leverage and risk scalpel potential for options strategies is very high. They directly offset and bend your exposure to the underlying stock. But if you’re just looking at expiration graphs, you might not realize your covered call can lose money if volatility goes up and stock goes down. And once you’ve “mastered” vega, you’ll get caught by skew.
The only way to truly learn about options is to start putting on positions and seeing why you lose money. Small positions of course, but there’s nothing better to introduce you to the multivariate risks. As the leg count or trading frequency ticks up, you’ll start to see more and more “unexpected” situations.
Derivatives are a rabbit hole of complexity, which can be very intriguing. But the twinkle doesn’t always make them a net positive, and markets don’t have an answer to be solved. The thirst for a solution can leave you bewildered, even astrologizing about the third order greeks of market makers.
Regardless of how many bells and whistles you have, every system is in need of both improvement and upkeep. The red queen keeps running, so your trading must adapt and compete with the other evolving species. Striving for simplicity and robustness is not the enemy of progress.
But with every additional system improvement, you introduce risk and tick up the ongoing maintenance. Nature (mother or markets) will grind against the man-made and turn manicured lawns into unruly jungles with crumbling structures.
In constructing an edge, there must always be an eye to durability. If you can’t pay attention to markets to catch every time an indicator drops below X, maybe it can be captured with something automated. And if you introduce automation, you need to monitor technical failures, dependencies, and upgrades.
Beyond operational resilience, lasting power comes from castles built on something more than sand. (Those fall in the sea, eventually.) A very simple and easy thesis is buying into the equity risk premium with a diversified portfolio - still a bet, but logical with a proven track record. A strategy of leveraging call spreads to buy dips in fundamental equities sounds attractive but has dozens more failure points.
Where possible, simplicity is king. For both logical validation and ongoing implementation, Occam’s Razor is an important tool to cut away the fat. Buying into a target date fund is both simple and durable. Opening up your account every week to “sell vol” is not.
If you want to put a wooden bauble on the well, or dash a little spice in your portfolio, know that complexity compounds. Just like a tree ready to fall, every surface that’s exposed is another vector for rot.