Life is Full of Options

Good Morning!

This is the Jumping Cholla (CHOY-uh). The newsletter that turns options market insights into a fun, easy-to-read email that helps you reduce your chances of getting pricked while trading!

And even if you don't trade, learning how to think like a trader builds a robust framework for problem solving, taking risks, managing a plan, and just living life.

Quote of the day:

"All decision making comes down to pricing volatility"

So I guess only a Sith deals in absolutes, so maybe ALL decision making isn’t about pricing volatility, but at the very least it’s about understanding the underlying distribution of your decision tree! (which is kinda more complicated and worse)

Of course, absolutes leave no room for error (not good for trading!) because then you’re left with an ideological bent of bullishness or bearishness. You’ll hold onto some bs “prior” logic for dear life (for my Bayesians out there, always update your priors!) and only achieve success after pure validation! e.g. financial twitter.

Being a good decision maker, means you know how to estimate “optionality.” At the Jumping Cholla, we believe that understanding options pricing and better yet, the expectations implied via their pricing (see: BANG number below), can make you a better trader but more realistically, just a better decision maker.

Life Is Full of Options

Do you go shoot dice with those guys in that back alley? What about that side bet while playing ship-capt’n-crew at the dive bar? Or buying that house with a 5/1 ARM vs the 30yr fixed? Do you buy the more expensive house with higher taxes in the better school district, or the cheaper house and send the kids to private? How about the “trip insurance” for ‘free cancelation’ after you buy that plane ticket? Hell, do you take the highway or the side streets home to “beat traffic”?

All these decisions have embedded option valuations in them (and FYI, there is no such thing as a free option, but if you find one you’re ‘bid for infinity of ‘em’).

Let’s dig into taking the variable vs the fixed rate mortgage. That’s relevant and should be easy…goddammit, actually solving this problem requires stochastic calculus and a continuous-time model, but f*ck it we’ll simplify it! For the couple of you whose curiosity has piqued, click the link.

Option: 30yr Fixed @ 6.95% vs. 5/1 ARM @ 5.67%

The 30-year fixed locks in your mortgage payment for the next 30 years. It’ll never change…firstly, does this sound cheap to you?! What did we say about Siths and absolutes! (sorry, bankers)

The 5/1 ARM locks in your mortgage payment for the first 5 years, then it adjusts every single year after that for the next 25 years.

Your Estimate: Mortgage rates will get back to 4% within 5 years, and then you’ll “lock-in” the remaining 25 years. Or fixed rates will be the 1% higher than they are now, and you’ll have to lock in at 7.95%.

Notice, I had to remove the continuously changing aspect of the 5/1 ARM to make this much simpler.

Here’s the decision tree for the 5/1 ARM:

Look, I’m not even going to get into interest and amortization differences in the first 5 years (that differential is calculable, constant and is trivial to subtract from the ARM vs the Fixed). We’re just gonna look at the “fuzzy” stuff i.e. the probability / the volatility associated with this decision. This is not how you accurately determine a 5/1 vs 30 yr (but it’s close)

Now, I know most of you failed freshman algebra, or at least “forgot” PEMDAS, so I’ll show my work:

Notice how the current ARM rate doesn’t matter, that short term cost savings isn’t what this decision is about: it’s about pricing future expectations! The same goes for real trading and especially trading options.

We are trying to determine the probability required to justify that the 5/1 ARM mortgage is fairly priced, given my simplistic binomial outcome tree (if you can read math, buy this book)

Yippee, we got a number! 25.32%…so, if you think there is a greater than a 25% chance that mortgage rates will be at 4% or lower in 5 yrs, you have to take the ARM! 

You are effectively betting that the underlying distribution of the yield curve is wrong! (again, given the above simplistic assumptions, not the real yield curve)

BANG for Your Buck:

As we keep saying, things are orderly, but persistent uncertainty smells like “risk off.” Market was down 18 handles yesterday (and more intraday, but not outside of BANG expectations) and volatility still came down. The implication is that the underlying movement was “expected.”

Here’s a scary thought, the market grinds down 10%+ but volatility never really “explodes” aka no capitulation. That makes long puts inefficient and borderline ineffective, and also short call volatility an extremely high risk / low reward proposition. In a next newsletter, I’ll write some ideas on how to capitalize on this “max pain” scenario (hint: it requires management)

Options Market Positioning

• 4100 = major resistance

  • With large option open interest, staying below it perpetuates the bearish lean.

• 4000 = critical support and entering large negative gamma land.

  • Since we’ve broken through 4000, dealers tend to hedge with the direction of the market, which naturally increases real volatility. Ex: as the market breaks, dealers need to sell the underlying.

  • But, we’re selling off, but volatility isn’t going up…well, the daily ranges are staying tight, and 50% of the option flow which determines underlying volatility is traded in 0DTEs hencethereforth, time-localized volatility remains depressed (FYI, this is a powderkeg)

• 3950 = large speedbump

  • The market dipped below but came right back to settle at this level. You could see that blasting through this level wasn’t in the cards yesterday, because volatility wasn’t consistently increasing as it sold off.

• Volatility bets are on!

  • As we alluded to last week, large VIX trades occurred that essentially bet volatility will go up precipitously (50% to 100% higher from here) into March through June.

  • We’re nowhere near 30 VIX…but I guess it’s hovering in the right direction for those bets.

  • See my pain trade above…worst case Ontario is no volatility

News/Reports

Typical bullsh*t. Couple a two tree Fed speakers. Yesterday, our unelected boy who can literally control markets with a single sentence, Minneapolis Federal Reserve President Kashkari, spooked the markets with “rates gotta stay high, because we don’t wanna look like dipsh*ts if inflation gets even worse!” Expect them to thoroughly telegraph what they will do to rates on their next meeting (March 21-22).

Housing related stuff will be interesting since the buying season for the Northern Hemisphere starts relatively soon.

On the heels of the almighty Fed, we have some inflation and unemployment numbers coming from Eurotrash land…so if we get an exertion of the move to the upside fading it probably makes sense, to the downside, I’d be worried about “positive feedback dealer flows” which can and will pour gasoline on the fire.

As always, pursue the process NOT the profits!