A little experiment — talking into a camera instead of writing.

The topic… “the most underappreciated aspect of trading”

A rough script

The Most Underappreciated Aspect of Trading

In the world of trading and investing, there’s a lot of talk about modeling and methods and all kinds of geekery. This is all well and good. If you read Moontower, you’ll see plenty of that stuff. But I want to talk about the most underappreciated aspect of trading today.

Before we get to that, think about what it must be like to make a market in newly listed options. It’s a relevant question today since it’s listing day for IBIT options. IBIT is the spot BTC ETF. If you’re opening the market for IBIT options, you have both Deribit and BITO options to help you triangulate a decent opening line.

If you were the first person to make a market in Pepsi options, you could look at KO vols as a starting point on how to model them. Just like a bookie who sets a line, you’d start with a good guess and then iterate based on flows. The key is you start with some model and adjust. Just like Newton’s method or any procedure that iteratively solves for the roots of a math function, the first guess isn’t that important and doesn’t even have a large impact on how long it takes to get to the “right answer.”

You just need something. A starting guess. A starting model. The iterative process matters more than the model, which you know is wrong anyway.

Let’s hold that thought.

A Bit of Crafty Wisdom

I’ll share a bit of crafty wisdom that market makers understand:

When you look at a price, you wish you could have traded it as counterparty to the aggressing order.

A simple demo: A quote is $1 bid, offered at $1.20 and it trades $1.15, and I ask you to pick what you’d want to do at $1.15.

You say “sell”. This isn’t a trick scenario. That’s the right instinct on average

Again, when you look at a price, you wish you could have traded it as counterparty to the aggressing order.

Now for the anti-climax.

It’s a fake idea because had you been on the price, the price would have been different. You would have affected it. This idea is like a painting to be viewed from afar. It’s not of any practical value, um, other than the fact that it holds the deepest insight in all of trading.

I don’t say this lightly. I can’t prove it. There’s a lot of nuance around it. But it comes from something deeply felt from spending the first half of my institutionalized career as an options market maker and the second half as a buyside options PM. I’ve traded tens of millions of option contracts. Far less than half electronically, too.

The Most Important Question

The first thing you should classify when looking at a price: is this thing bid or offered?

Do they love it, or do they hate it?

I’m hesitant to generalize to other forms of trading, but vol trading is a fundamentally contrarian endeavor. You hold your nose when you trade. If you like your trade, you should be nervous.

You’re uncomfortable? Get used to it. Bruh, that’s the job. To fade everyone else’s greed and fear.

Analysis vs. Price

I said I can’t prove it, and taking even a pro’s word for something is hard. I’m with you. Skepticism is a good reflex, especially in finance. But I’ll take a stab at making my point more concrete.

I saw a tweet this morning from a mutual who I respect. It was about how he liked selling puts on names that have plenty of cash, flooring the value of the stock much higher than 0. Let’s accept this, and we’ll call it analysis.

“I did analysis, and this stock is worth, by sum of concrete parts, at least $10, whatever.”

In a poker context, he’s playing the cards. He’s done the work. He’s done the math. The motivation to trade is resting on analysis. On the cards.

However…the outcome of the trade depends on the interaction between the price and future states of the world, both seen and unseen. You must think of any trade as an instance of a decision process that you are repeating over the course of time, albeit with different details each time.

The analysis in this case was focused on states of the world, which is great. It’s part of what drives the outcome of the trade. But let’s zoom in on the idea of price, since it’s as critical to the trade as the health of your Siamese twin. The outcome is no less about the price than the analysis.

Critical Price Considerations

I don’t need to use a concrete price. We just need to consider: is this option—this put option—bid or offered? Forget the option surface, forget the dollar price, forget any quantitative analysis.

Does the world look at this option and think, “this thing deserves to be sold”?

You need some theory of mind here.

When you imagine how other people look at this option, what do you think they think? How hard was it to see how much cash the company has?

Let’s say that you have reasoned that, in fact, no reasonable person would care to buy this option.

So, what do we know about the price?

Well, if there’s any volume, we know it’s trading. And if everyone who does analysis comes to the sanest conclusion that this option should be sold, then the price has a crowd on the offer, and the buyer is a market maker who either:

1. Thinks the price is cheap against something else in the market they can sell against it.
2. Thinks there’s enough discount baked into the price that it’s worth owning.

The Mechanism of How Crowded Sentiment Gets Disappointed By The price

It’s so often the case in options that extreme one-way sentiment sows the seeds of the counter.

The market buys so many call options that it causes a gamma squeeze. BUT if the options were so expensive that the gamma was actually quite small despite the number of options bought, then as the stock goes up to the immediate delight of the longs, it disappoints.

See, the longs were all motivated by a quick strike, not long-term holding. So, the once-call buyer is a future stock seller. If the stock doesn’t go up quickly and far enough, the call holder starts wondering if they are a bag holder on a rapidly decaying option contract.

A build-up of open interest on one side of an option contract can be thought of as an order book distributed across time. There’s stock to buy or sell in the future—it’s just which side of the open interest will need to do it and what are the properties of that cohort when averaging their behavior.

(If you don’t trade options, you may have heard a similar framing in pure stock trading: every short is eventually a bid for the stock, but this is not as strongly true for longs.)

If You Only Have Room For 1 Takeaway

For a trade to be successful in expectation, it must be attractive NET of the fact that it is bid or offered.

This means you can make guesses about the good side of a trade without doing any analysis. Ask yourself, “What would everyone want to do with this contract or instrument?” and recognize that the price that is actually trading is sufficiently profitable to find a counterparty who is willing to tolerate loneliness and ridicule.

Always ask yourself, “At this price, what is the market begging for?”

The inner monologue as I would trade against someone was always:

“Eh, you’re probably right, and holding this is gonna suck for me, but the price you’re paying is gonna disappoint you.”

You are welcome and invited to do all the analysis you want, as if investing were a problem set. But remember: the exams are graded on a curve.

Did you beat the spread NET of it being bid or offered?

Practical Tips

General tip:

• If you do finance, then study finance. Balance sheets, accounting, and so on.
• If you’re in trading, study gambling and actually do trades.
• If you’re in investing, you need to do it all.(Topic for another time, but that last fact is why you would expect the number of exceptional investors to be far smaller than what the investing world would have you believe. Said otherwise: the number of good investors is smaller than the number of good track records.)