Focus On Convexity: Trading On The Long Side
If a trader being short convexity runs the risk of getting flattened by the proverbial steamroller, what about traders who are long convexity?
How do they fit into the penny-picking-steamrolling aphorism?
First of all, we need to understand what being long convexity in trading actually means.
Long convexity traders are those who make money from the low probability events that inevitably occur in markets.
A good example of this would be the opposite of the option seller described in Part 1, that is traders who purchase out of the money options (often far out of the money). They do so in anticipation of markets making a big directional move, netting them a handsome profit in the process.
In other words, they are long volatility (long vol), and hence also long convexity. Metaphorically, these traders are the ones trying to jump aboard the steamroller as it flattens everything in its path.
Being flattened by a steamroller brings to mind financial disasters such as the Great Financial Crisis in 2008, or the massive global selloff in markets during March/April of Pandemic 2020.
However, it is important to note that the low probability events that long convexity traders profit from need not be so dramatic.
For instance, CTA’s (trend followers) are generally long convexity traders, and the low probability events that they trade are markets entering/exiting trends.
While this may sound strange, markets actually spend most of their time trading sideways (70% of the time, according to market lore). Hence, a market starting to trend is actually a low probability event, and if traded properly, a great source of profits over time.
The problem with being long convexity in financial markets is that one might go bankrupt before the “long term gain” comes along. This is often referred to in financial circles, again in a darkly humorous way, as “death by a thousand cuts”.
But what exactly are these cuts, and how do they come about?
The exact nature of how the cuts are made differ by strategy.
For CTAs, they come about from being stopped out multiple times in choppy, sideways markets that refuse to trend for a sustained period of time.
For traders who go long convexity via purchasing options, the cuts come from their options expiring worthless as they patiently wait for volatility to explode.
Subsequently, “Death” comes about when long convexity traders lose all their money before the low probability event comes about. Since their trading accounts deplete slowly over time, with small loss after small loss, rather than all at once as happens with traders caught being short convexity, the process is referred to as a “thousand cuts”.
Of course, this begs the question: If being short convexity leads to being flattened by a steamroller, and being long convexity to a slow death by bleeding, aren’t both strategies equally unviable?
To be concluded…
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