Focus On Convexity: Trading On The Short Side
The financial version of apples and doctors (or flossing and dentists) is the darkly humorous “Picking pennies in front of a steamroller.”
But how does the concept of convexity apply in trading?
Just like in life, convexity is about the relationship between small payments and asymmetric outcomes.
However, in finance, being short convexity can actually earn one an income. This applies specifically to options trading, where traders who sell options receive the option premium upfront.
By selling far out of the money contracts, that is options that have a very high probability of expiring out of the money and thus worthless, a trader can earn a consistent, albeit relatively small income.
This sounds like a dream to most people, especially inexperienced or new traders/investors.
However, a strategy that is overly focused on selling options is a very dangerous strategy – akin to not flossing one’s teeth.
Simply because financial history has shown that rare events, which lead to massive disruption in markets, occur a lot more frequently than current financial statistics account for.
This means that by consistently selling far out of the money options, a trader is also consistently exposing themselves to such massive disruptions.
Typically, when such rare events occur, losses incurred by people who were selling options tend to far outweigh whatever gains that they had made.
A good example of this would be the large number of traders who were selling US equity index options going into March 2020 (specifically puts), just before global lockdowns. These people were “short vol”, which means they were short volatility, and is another way of describing selling options.
Since an option’s price increases when volatility increases, selling an option is taking the bet that volatility will not increase by much in the future; hence the trader is in effect shorting volatility.
As we know, global markets grew extremely volatile extremely quickly, wiping out anyone who was short vol. In other words, they were flattened by the proverbial steamroller because they were busy picking up pennies by selling puts.
It is important to note that selling options is not the only short convexity strategy used in trading the financial markets.
Arbitrage strategies (e.g. merger-arb, index-arb) tend to be short convexity as well, along with any other strategy that, in general, exposes a trader to potential losses that are much larger than potential gains.
All these strategies run the (high) risk of being flattened by the steamroller, which is of course, a representation of the second part of the convexity deal – asymmetric outcomes.
Unfortunately, people tend to forget about this once they see the possibility of earning consistent returns. This inability to respect, and/or recognize the nature of convexity in markets could be due to a combination of psychological and statistical blindness.
Psychological because the vast majority of humans seem to be wired in such a way as to emotionally prefer consistent returns.
They simply make us feel better, and in seeking the emotional security of feeling better, we expose ourselves to negative asymmetric outcomes.
Statistically, the same inability to recognize that rare events really are not that rare in financial markets contributes to our failure to factor convexity into our thinking. This is primarily due to the ubiquitous misperception that markets (and life) follow a normal distribution, a.k.a, the bell curve.
Unfortunately for those who learn, believe, and eventually come to model their perspectives on it, markets (and life) are not normally distributed.
Instead, they follow Pareto, or more generally, Power Law distributions, where rare events are much less rare than in bell curves.
Given that this is the reality in which we live, would it not be wiser to adapt to convexity, rather than be crushed by it?
To be continued…
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