When you’re heading out to shoot big game, you need the right gear.
Camera equipment of course - heading into the Masai Mara with a firearm is cruel, savage, and you’ll rightfully land in jail.
Despite having earned a bit of YouTube revenue for a ski crash video I filmed in college, most of my experience to date had been with either an iPhone or a disposable Kodak at summer camp.
Fortunately I know a guy - he happens to be my father in law - who spends a lot of time around cameras. Before taking his daughter out to the plains of Africa, it was time for a crash course in f stops and apertures.
These days it’s pretty easy to take a good picture. Throw on a sepia filter or switch into portrait mode. Voila, the perfect social media post. The airbrushing takes place before the image is stored.
But to take a great picture, something that could hang on your wall, you need to fiddle with settings and knobs. Framing the moment requires more than a drive by. The artist must align their lens with the subject and the subjective. Capture just the right amount of light.
Like a good conversationalist, a photographer is in tune with the vibes. Saturday morning soccer match in the suburbs or the moon dancing over Lake Titicaca? The magic hour. It’s about the subject of course, but also showing exactly how their environment contextualizes them.
There are two main levers to determine how much and how long light hits the camera sensor. The aperture is controlled by the F-Stop, which adjusts wider and narrower. The shutter speed determines how long that exposure lasts. The seminal shot is a perfect balance of exactly how much for how long.
That sounds a lot like investing. If you know how your objectives match your time horizon and risk tolerance, you’re up there with Ansel Adams.
One of the great investment philosophers is Jim O'Shaughnessy, whose blog and podcast Infinite Loops is unmissable. He recently had a conversation with author Luca Dellanna about how to win long term games. (Emphasis mine.)
One of the first things you notice when you're studying investor behavior is that they are hyperbolic discounters. They focus on what a stock is doing today or if they're seemingly longer term in a quarter or a year. And that is mostly noise. One of the things that I often say is if you change your focus, you could change your future. And changing your focus requires, as you advocate, a longer term period of time. Because a very short time horizon reduces your aperture. It's like blinders on a horse. And you only see very, very limited options.
The two use the stylized example of setting a goal to earn $1M. If you have to do that in the next week, you’ll resort to something dangerous with long term consequences. Poaching lions or selling a kidney. If you’ve got 30 years, putting together an extra $750 per month and compounding at 8% offers many more savory choices.
Aperture matters even more with options investing. The leverage that these scalpels provide makes timing decisions extremely significant.
When your range of focus is the next 6 hours, options have to price the potential for extreme outcomes. The SPX contracts expiring at the end of today opened with a straddle price of about $35 - meaning the S&P 500 is expected to move less than 62 basis points on the day. Most days it’ll be a lot less.
Jamming those prices back into the options pricing model, we get an implied vol of 28%. Add 24 hours of expiration and implied vol drops to 19%. Get over the weekend hump and you’re back down to 12%, which is where the 30 day number sits also. It’s almost surprising how few turns it takes for “n” to be significant. Zigs and zags quickly offset.
In 0DTE trading the aperture is incredibly tight, and traders are pricing kidney sales not decades of exercise and healthy eating. Tails only happen once in a while, but until the bell rings it could be today. You need to keep enough dollar value in that option to account for the fact that averages are the net of extremes.
This makes short term options incredibly greek rich. This is desirable to both buyers and sellers of options. Compared to other expirations, there is significantly more pro to pro activity here as dealers exchange risk profiles.
The buyer is happy to pay only a few pennies for a lot of gap risk coverage overnight in a short dated option. The counterparty seller says I can whack these every day and make a lot more money selling 22 dailies compared to a one month option.
But here is where your aperture must align with your objectives. Selling calls every day against your equity holdings for income is a long term trade plan, that’s using short term products.
The ten delta call in SPX is about $2 today. Wake up every morning to sell that, assuming the vol environment is constant (it never is), over the course of the next 22 trading days (one month) you’ll have about $4400.
To collect the same amount of premium you would sell the 33 delta call a month out, or only collect $850 at the 10 delta level. Overlays that only think about the percentage yield and start annualizing it are ignoring an important understanding of distributions and time.
To make that $4400 clean, you need to take a coin with 90/10 odds and flip it heads 22 times in a row. While there’s only a .00002% chance that happens with a fair coin, the “90 delta” coin has about a 9.8% chance of emerging unscathed. (Whether you’re surprised high or low by that figure would tell me a lot about your trading style.)
Each loss you take when the SPX pops more than ~60 points in a day is going to dig into that theoretical gain. Unbounded. When she moves she moves, and an 80 point day instead of a 60 point day wipes out half a month of gains.
Sell spreads, manage your deltas and expectations, adjust for vol environments - there are ways to make this a viable strategy. But is that really the picture you want to take, the portfolio allocation you want to manage?
For most investors, using options to manage convexity risk should take a wide aperture. The gyrations that make up realized volatility leave deep cuts on a daily basis. It’s only over longer horizons that the market arrives at efficient prices.
Rather than annualize what daily covered call or cash put sales will net you, consider what a 20% loss looks like to your lifestyle. If that matters because you're relying on savings or have a low risk tolerance, you don’t want to be playing in options less than two months out, you want a lot of turns and a fair risk transfer.
Letting too much light in your camera leaves the celluloid scorched and washed out. Sunlight is a fantastic antiseptic. So if you want to douse the daily movements, widen your aperture and extend the horizon.
Continue the conversation with Portfolio Design where in tomorrow’s edition I’ll talk about how to implement this wide aperture.
Dig into the mechanics of how to structure defensive options positions that take advantage of longer time horizons. Explore how various different setups pay out, and behave through the lifecycle of the trade.