Liquidity Ostrich

I have a friend who turned $2k into $6.5mm, eventually cashing out of the crypto markets with about $2.5mm. Because of the path, his framing is “what could I have done better?” He came to me looking for perspective on risk management.

I began my reply with a story I recounted in Talking To The Diamond Hands. In 2017, I was at dinner with a young product manager at Coinbase and an older tradfi friend that brought us all together.

At some point, the product manager who was about 22 went to the restroom. The senior guy, in a hushed tone, turned to me.

“So one of the reasons [the 22-year-old] wanted to talk to you is he has a high-class problem. He’s sitting on a giant pile of ETH he’s been mining since college. At current prices, he’s rich, but doesn’t know anything about investing. He needs advice and we thought you could help.”

As I was soaking that it in, our young tycoon was returning. There was no need to tippy-toe. The whiz kid cut right to it. He explained respectfully and with great maturity his “problem”.

What did I say to him?

“I don’t have much to say. If you listened to my opinion years ago you would never be in this beautiful predicament. I would never have held on this long, so there is nothing I can say that you should listen to. But now that you are here, I can offer one way to think about it — sell an amount that makes you feel like you never have to take a job just for money. You are 22 and achieved freedom.”

I don’t even know if this is good advice. It feels like such a dowdy perspective that it can only come from someone who would never have scored that big.

I re-told this story because I wanted to highlight an important point — there is no risk management rule forged from the business of trading that condones having most of your eggs in one basket. In other words, there’s no vetted risk management framework that would have let you turn $2k into $6mm so the entire conceit of “what could I have done better?” is misplaced.

That doesn’t mean it was wrong necessarily. It depends on your goals.

If you need ransom money by Friday, not betting everything on a roulette wheel tomorrow might be the riskiest course of action.

I’ve explained how bet sizing is not intuitive. I’m reading a Man For All Markets now, and there’s a scene where a 38-year-old Richard Feynman explains to Ed Thorp how he agreed to “be the house” for another friend who wanted to play roulette. Playing as the house, Feynman taps out after losing $80, underestimating the short-run variance of the game despite his advantage. The Nobel Laureate’s failed gambling intuition cautions us mortals that in some areas you should “work out the math”.

Now notice that my friend’s pickle is really not even at the level of bet sizing where we can triangulate on a reasonable range of answers given some constraints. My buddy’s dilemma is philosophical. What are constraints and the goals? His first task is to back up and find the inputs that reduce to “what matters to me”.

It reminded me of another conversation with a family member who was trying to solve what I’d call a “thymos-question” with a spreadsheet. Look, if you have a high income but feel the burning call to press your full potential in something that is just not lucrative, Excel isn’t going to help. You can’t generate a 3-D chart with a binary z-axis labeled “living the one life I got” and “dead”.

Luck is not a strategy. But it exists. If you want to bet on variance maybe the most practical thing to remember is “trade less when you don’t have an edge”. You are in the exact mirror situation of a casino with a small edge that wants you to pull the handle every day.

Once you know you’re gambling and decide that even long odds are the only acceptable way forward, try to minimize your contact with the rake, and shoot your shot.

What Illiquidity Hides

All option traders have stories about days they regret going into the office because they had a massively winning option position that they mitigated by hedging too aggressively. A $1 OTM put that goes $10 ITM, but they bought stock the whole way down hedging the delta. Or a short straddle that pins on expiration but the stock’s daily range meant they bought the high and sold the low. In the long option case, liquidity was the enemy — you would have preferred the stock gapped down $10.

Think now what this means for options backtests that pretend closing prices are the only prices. Your sampling frequency should align with the frequency by which your p/l matters. If you sample daily but your intraday risk and p/l matter you are acting like an ostrich.

This observation is rarely overlooked in short option strategies, at least by non-charlatans, but it’s worth noting that long options strategies that over-index on gapping price charts will overstate their attractiveness since the gaps are a gift in “not being able to rebalance”.

Since long option p/l’s can have highly skewed distributions (ie most of the profits coming from a few trades) this is not just a theoretical concern. Consider the expected value computation for optimal video poker play:

The Royal Flush, an event that happens 1 in 40,000 hands (if you played a hand every 10 seconds and didn’t sleep from Monday to Friday you’d expect to get one Royal Flush) contributes 2% of the game’s return. Said differently, if there was no possibility of a Royal Flush the house edge goes from .5% to 2.5%. This would be like the bid-ask spread in a $10 stock going from a nickel to a quarter. Annualize that churn in any strategy and see what happens to the “alpha”.

There’s a Wario world perspective (cc private equity) in which the downside of illiquidity gets moral equivalence with its upside. If you can’t re-balance you are safe from yourself and behavioral trading biases. Like pretending that every gap comes back. That’s the unsaid assumption that discourages you from selling at in-between prices. (If close-to-close vol is much lower than OHLC or tick vol then you want to sell straddles and go on vacation. Basically betting on mean reversion. Too bad this volatility behavior is only known in hindsight. Conversely, if you are long gamma you want to hedge more frequently if you know that close-to-close vol computations are smaller than range or tick vol computations of realized vol. If only you could know in advance.)

Well, this week Matt Levine wrote a banger called Structure. First an echo:

One cynical way to understand private investing generally is that private investment firms — venture capital, private equity, private real estate, etc. — charge their customers high fees for the service of avoiding the visible volatility of public markets. If you invest in stocks, sometimes they go up, and other times they go down. If you invest in private assets, they don’t trade; sometimes they go up (because companies raise new rounds of capital at higher prices), but the companies and the investment managers take pains to keep them from going down. This makes the chart of returns look much nicer — it mostly goes up smoothly — so the private investment managers can charge higher fees. We talk about this theory from time to time around here.

The real meat of the post is describing how start-ups, rather than taking a down-round in funding, prefer “structure”. Levine walks through the mechanics, but the gist is that the new investors who subscribe at the stale, overpriced valuation are getting an embedded put option (it’s more of a put spread since it only protects you so far). This gives the illusion that the valuation is unchanged, but only because you didn’t assign the put value. If you wanted to compare valuations over time, you’d need to back out the value of the put, to see how much the private company’s value has actually fallen.

Instead, we are left with the optics that the valuation is the same but the economic reality is that it’s lower. That should tell you quite a bit about the dog-and-pony culture around private investing. (In fairness, Levine explains how most insiders understand all this but that makes the gaslighting even darker in my axiological naivety).

I’d accept the pushback that it’s all made up anyway so who cares if we decompose the price of the glitter from the measure of fairy dust.