The “No Easy Trades” Principle

My “No Easy Trades” Principle

A recurring theme here is the wisdom of markets. If you find yourself constantly disagreeing with prices visible to anyone with a smartphone you probably get invited to lots of poker games. This doesn’t mean markets are always right. It just means nobody can claim there is easy money in slanging investments around. It means your guess is not consistently better than the market’s. I highlight that distinction because it seems to be lost on efficient market detractors.

So my definition of markets being smart is not academic. It’s actually a survival heuristic — there are no easy trades. Today I will discuss 3 things.

1. What this heuristic looks like in the options market
2. The puzzle I stumbled into when applying this logic to stocks.
3. How the puzzle got cleared up.

Before I mosey into this we need to agree on a stylized fact.

Investment returns are driven by:

1. Actual earnings (returned to shareholders or re-invested)
2. Expectations (risk discounted of course)

So a stock’s return is driven by actual earnings (I call that the “realized”) and changes in the multiple (the forward-looking growth prospects is the “implied”). Same with real estate. If the cap rate is zero in one location and 10% in another it’s usually investors factoring in different growth rates. The actual rent is the “realized”.

As time passes, the market will pay attention to the fundamentals on the ground to revise the growth rates. Is this investment cash-flowing more or less than expected? So the “realized” earnings interact with the expected or “implied future earnings”.

Option Returns Are No Different

First, some reminders about options:

• Volatility is the standard deviation of a stock’s return. The amount of volatility that transpires until an option expires is a large driver of an option’s value.
• Nobody knows how much volatility a stock will experience during an option’s holding period.
• We know the other inputs into an option price. Since the other inputs are known, we say the price of an option implies a volatility.

For somebody managing a hedged options book, the p/l is driven by:

1. The realized volatility of the underlying

If the market bounces around 2% a day and you purchased the option implying 1% per day you will “capture” p/l in excess of the option’s time decay. (The p/l due to “gamma” exceeds the losses due to “theta”)

2. The implied volatility baked into the option

If the market suddenly believes the future will be more volatile, it will bid up option prices. This will lead to profits for someone who owns options. (The sensitivity of the option’s price to the market’s vote on volatility is known as “vega”)

Option Markets Are Smart

Without getting into the nature of realized and implied volatility it’s sufficient to say that they are mean-reverting. If a stock becomes more volatile, say moving 2% per when a longer history pegs it as a 1%-per-day type stock the options prices will increase to price the extra volatility. But as the realized day-to-day volatility reaches extreme levels, say 5% per day, something we may have seen in March, the option implied volatility will likely not rise by as much (I’m hand-waving term structure and more, it’s not necessary to the point). Why does the implied volatility not keep up?

Expectations. The market understands the shock is temporary. So there is no easy trade. People that want to sell or short expensive options will be disappointed to find that they will experience negative gamma p/l during the holding period because the realized volatility will exceed the implied volatility they had shorted.

And option longs who may be enjoying the positive gamma p/l (or “carry”) know that they have bought a high implied volatility that is eventually going to recede.

When option volatilities get very low the inverse dynamic occurs. There are period when the SP500 will realize less than 30 bps a day but the market never sells you options at such a low implied volatility.

It’s simple. The market will not let you have a position that simultaneously:

1. Carries well
2. And has a tailwind in the direction of the mean-reversion

Classic dilemma. You enjoy one while fighting the other. Market implied parameters reflect expectations. But expectations do not vary as widely as what actually happens because volatility is a mean-reverting quantity. Net result: no easy trades.

The Puzzle: Is The Stock Market Smart?

I presume the stock market is smart and must follow a similar principle of “no easy trades”. By analogy, I mapped implied volatility to P/E and realized volatility to actual earnings. So if profits (earnings) were high, I’d expect forward P/E ratios to discount the elevated earnings. Otherwise, it would seem like an easy trade to take the other side of a market that extrapolated unusually high earnings into the future. Just because LeBron drops 50 points one night does mean the “point futures” market is “49 bid” for the next game.

Now earning themselves are not mean-reverting. I wasn’t quite naive enough to apply my cargo-cult thinking to that metric. Enter fund manager John Hussman. He argued that profit-margins, which have been extremely high, are both mean-reverting AND being extrapolated into the future via fat multiples.

This was to be the rare set-up of an easy trade — a bear case with a double tailwind. Luckily I didn’t trade in my PA based on this. For all the $20 bills on the ground I miss out on, my disbelief in their existence has also saved me from being short stocks for the past 5 years.

So what’s the deal with the stock market? Can it possibly be extrapolating mean-reverting metrics with straight lines?

Carry On, Nothing To See Here

Well, it turns out there is no puzzle. Profit margins aren’t a metric that matters. It’s return-on-equity that matters. Get all the details from @jesse_livermore in his paper Profit Margins Don’t Matter. It’s several years old but the thinking that permeates through this paper is better than 99% of finance stuff you might read today. And if you are weak on accounting like I am you’ll want to bookmark this one.

Extra observations on the options vs stocks analogy:

• When an option has lots of time until expiration the implied expectations dominate its price. Conversely, as an option approaches expiration, the realized volatility will dominate. This manifests as the option’s vega decreasing while its theta and gamma increase.
• Unlike options which have fixed expirations, real estate and stocks are more like perpetuities making them highly sensitive to expectations.

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