Continuing with the Indexing Blackpill

 I wanted to follow up on my last post, going more specifically into the Index/Passive structure, mostly from Michael Green's work I've been following- put much more eloquently and completely:

https://www.youtube.com/watch?v=x-rJciYZmi0

https://www.youtube.com/watch?v=6SVEaK7eDNk

https://www.youtube.com/watch?v=L_8IBc6Euqc

https://www.youtube.com/watch?v=sMwg6fqseP0

In the wake of every market commentator yelling "it can't keep going up, P/Es are 1000, this is the biggest bubble of all time, etc" at some point we have to look for something more quantitative.  Unlike the yelling, Green's analysis is mathematical/mechanical:

Does Vanguard/Fidelity/'passive' get inflows? (any work retirement plan, heavily covered by lobbyists)

Then-> buy  (at any price)

IF (clients get redemption/ outflows)

THEN-> sell (at any price)

This is it. This is flows>fundamentals (or flows are fundamentals if you will). Note the largest market force does not have qualifiers/conditions (if(interest rates>x), if(SMA<x), if(P/E<x))

This feels like a revelation, where you watch the 'scientific community' looking up to the stars- "well, Zeus must be throwing those lights around, how can that one keep moving that way!"  Then Galileo walks in and just measures the movement with trigonometry... 

Like walking into 1400AD with an astronomy textbook, looking at markets now with flows as the main lens feels like my other favorite metaphor "this is water".

Now lets address the issue with the Fed/ raising target inflation issue, as the last of the "macro" commentators are pointing to the massive inflation era we are going to hit, which will be good for commodities, gold etc:

In the above structure of Vanguard as forced buyers/sellers- does SPY behave differently from a commodity? If industry requires raw materials to build/ oil to move etc, they are forced buyers at any price (with a lot of options structures/contracts locking in rates over time).  Vanguard is an industry that requires buying a certain commodity at any price to fulfill its mandate- the commodity is just SPY...

This is important enough to put in my pantheon of market blackpills:

1. Petrodollar/ US reserve currency status- vs "why is our military budget the biggest in the world? why can't we just spend all that on healthcare and daycare?"

2. Warren Mosler / "descriptive" MMT which shows the structural accounting of why debt ceilings don't matter in the midst of decades of goldbugs yelling about it.

3.Index/Passive flows

(a close 4th is the Jeff Snider Eurodollar system, that might go under US reserve currency for now)

So given this, what do we do? I'm even more committed to the ratio structure I described in my last post-

1. Targeting the biggest movers in the tech/call skew/meme bubbles with liquid options

2. Looking for spreads that are fading another 10%+ upside weekly move, with enough strikes to allow further legging in to higher spreads.

3. The ratio spread allows the potential theta to double as the spread moves 'against' you, while financing potential long legs to hedge/ scratch out of the week.

4. no downside risk/vega. 

(This is the most important part about the structure. From Green's work, the passive % of market control exacerbates both upside and downside moves, meaning the "sell at any price" component listed above implies crazier crashes/ V rallies.  In this spread structure I'll be getting burned on outsized continuations after rips up, but the important part about this is I will be making adjustments on green days when the market is working.  If you have the downside risk, your adjustments on crashes will be potentially when bid/asks are a mile apart or worse the market is not working- depending on your broker)

What scares me even more is Green's work on showing the decreasing to potentially negative alpha of short option strategies, leading to a potentially darker blackpill: the only approach to this market is long vol / long straddles.  (If you are more interested, please go through the above clips which include some slide decks)  

I'm not mentally ready for pure straddles yet, primarily from the mechanics of not having adjustments to make, and not being able to model any ROI based on some theta.   Who knows, I might eventually take the final pill and delete my twitter as the name has me locked in...

Let me know your thoughts on twitter-

Option approaches to this market

 In the last few weeks a few themes have been hitting me:

• "passive bubble" - noticing a resurgence in discussions on the indexing % of market- tweets,
  
  realvision, other youtube
• TSLA, AAPL , others ripping- specifically having crazy skew numbers in the options, ie TSLA weekly strikes going to 2x spot
• Other constant discussions on tail risk/ general portfolio construction- ie bonds having no place in a 'retirement' portfolio 

In the journey to constantly be reevaluating, I'm meditating on how to approach this market, and create option structures that make sense.  As I've said before, I'm not a 'long stock' person, as there is no way to model annualized roi or risk, and no adjustments to make.  On top of that, as I'll get into, I don't think 'long stock' as a structure makes sense in the current index controlled market.

In addition to "no long stock," I'm increasingly getting away from short puts in the big liquid underlyings, as I don't think the risk structure matches how index controlled markets work.

As almost any passive/index mechanics video will go into, Vanguard/Fidelity et al. are forced buyers or sellers at any price, meaning the characteristics of the large liquid underlyings (FANG) are "grinding/shooting up" or "crashing down". 

 The passive flow dynamic doesn't really allow for a "grinding down" in the FANG/ large caps as there is a constant wave of forced buyers, and sudden liquidity events.  As many will lament a lack of "price discovery," i'm looking at if from a purely mechanical angle: I don't think the current large caps structural movement matches short strangles/condors or even short puts.  Short puts have to be constantly rolled up into decreasing vol premium, and keep the same downside risk.  Strangles have the same downside, and almost more often are burned to the upside gamma.

Yes, there are other ETFs like non US EWW EWZ EEW, etc that are potentially better structures for pure short strangles, given the passive flows, but those are not a main focus of mine.  Those don't have the same upside call buying/ gamma squeezing, and overall have way less tail skew making certain spread structures unavailable. In a correlations =1 Feb/March scenario, those strangles wouldn't help.

Given the "grinding up/crashing down" structure mentioned above, the main structures I'm looking at are call ratio/ calendars.  Depending on the underlying/skew, I'm looking at either long verticals and a short call further out to finance it, or a longer dated long call vertical, with shorter term short calls against it.

For example a recent $TSLA position:

Trade on Aug 17th

+2 Aug 21 1990 call ~12.27

-2 Aug 21 2000 call ~11.48

-1 Aug 21 2300 call ~2.59

for a total credit 1.01, with no downside risk.

(I ended up taking it off for another ~1cr, so basically doubled the credit in 2 days as it moved up. Little did I know this could have hit the max profit by that friday...)

The point of this structure is to flatten out the damage as these crazy skew stocks move against you, and actually add on the chance of a higher win in specific cases.  Selling a normal single call and taking the higher credit would be a bloodbath all the way up to expiration.

In many cases when the 2 or 3rd day is way against you on a short single, this version would let you get out at a profit at that point, and potentially roll the strikes up to keep going safely.

As a final aside on this structure, I've been wrestling with the pursuit of convexity since Feb/March, when I took off some long vol hedges very early for a few hundred profit, which would have later gone up to ~20k.  When the option structure is pure short 1 option, with no ratio component, there is no chance to have outside good events, only crazy damage against you.  This $TSLA spread kept properties of the single short option, while giving multiple paths including a crazy max profit which my psychology wouldn't even allow to materialize, but nevertheless is there in the background.  I plan for annualized ROI based on the minimum credit only, but still have a chance to wake up to a bigger win.

This structure only works in the high skew and specifically high notional price stocks, a space which curiously enough is shrinking this week with the TSLA and AAPL splits.  When the notional price is lower, the spread section of the trade is about the same, with the single leg credit being much smaller, and not able to compensate the spread.  I'll have to look at these chains post split, but after that we probably only have AMZN and GOOG to look at.

A trade from the 2nd structure in MSFT:

on Aug  10

+1 Sep 18 215c ~5.84

-1 Sep 18 220c ~4.24

for total debit ~ 1.60

then

-1 Aug 14 220c ~.34

giving the whole trade a potential $5 spread for 1.26

Then as each week went on, i'm selling close to the 220 strike for the week, or hopefully a little higher, to lower the cost of the $5 spread to almost 0 or a credit.

This trade has more downside, but is possible in the lower skew/ lower notional price stocks.

The core idea is the same though, I'm getting potential to access the "grinding up" characteristic of the large cap/ passive stocks, while lowering or eliminating the "crashing down" liquidity events.

On a day to day PnL level, this eliminates the large moves from short options going against you, even if the total spread will be a loser, the long vertical flatten out the damage.  

These are 2 samples that I really think harness the structure of dealing with passive right now, more than boomer 'long stock + long puts', or a blend of several long "uncorrelated" underlyings.  

These structures are meant to harvest the current market structure, up until the next major shift or liquidity event, at which point we are not blasted by that downside move, and can re access at our leisure as the data comes in.

I am just constantly blasting my blood pressure seeing "professional" market idiots with the "well I certainly wouldn't long OR short X here, it could definitely still go up a ways, but will obviously crash at anytime... I think there are much better opportunities in Y (which has non existent options and has been flat with long deltas only)" 

That is what markets are, making an assumption and picking a structure, trading profitability for probability.  

Let me know on twitter!