Interview: Decision-making for investors with Kris Abdelmessih
Investor Interviews #4, Part 1
Alright, alright, alright!1
Kris Abdelmessih from the Moontower Meta blog was a delightful find for me last year. I stumbled upon “Why Investing feels like astrology” and went on a binge-reading spree through his articles. For those unfamiliar with his work, Kris spent 20+ years trading options, starting out at Susquehanna (SIG). He writes about options, volatility, investing, learning, and more.
The beauty of his blog is that there is something for everyone regardless of their background. His wikis and reading lists are fantastic resources for beginners who want to educate themselves. This interview with Kris is split into two parts:
Lessons from options trading that can be applied to investing and life
How individual investors can educate themselves to be among the best
This is Part 1. Part 2 goes out next week - so stay tuned. If you’re strapped for time, here are the top actionable insights you can take away from this interview -
Your investing goals and direction should shape your strategies. Don’t be a day trader using fundamental analysis tools or vice-versa.
Think about the market as a casino and yourself as a player - The house wins... most of the time. If you think you have an edge, be really skeptical. Why isn’t anyone else spotting it? Avoiding a bad choice is as simple as asking – why am I getting a look at this?
Savings and investments are for maintaining wealth you’ve earned, but human capital is how you get rich or earn.
When it comes to investing and trading, there are two levels of probabilities to consider: You have to play the cards, and you have to play the opponents.
Event probability doesn’t exist in isolation - A low probability trade executed enough times can lose you a lot of money. Learn to think about probability on a per-trial basis to see how it will really affect you.
Passive investing doesn’t come without risk - Passive investors are paid a risk premium for the flow they provide to the market.
Options are a good tool to teach investors to think in specific terms - to be rigorous about bet expressions and the basis risk between the idea coming true and actually making money.
Don’t play with money you can’t afford to lose.
There is no magic formula. The majority of the work is mundane but rewarding.
I highly encourage you to read the whole piece. It’s one of the most thoughtful, detailed interviews I’ve done so far! There are four sections in this part:
An options trader’s investing journey
How to make better decisions in investing and life: A crash course
Options trading: An inside look
Starting from scratch with options
Let’s jump right in.
An options trader’s investing journey
MS: From being an active options trader to now: Can you tell me a bit about how your mindset towards money and investing changed? Can you think of any milestones in your journey?
Kris: I think my answer is going to be more interesting (you might even think I’m a moron…and you wouldn’t be wrong) than useful but here it goes.
The entire concept of investing was fairly foreign to me. My parents never really had enough savings to invest. I knew I wanted to make a lot of money, but I never thought about what I would do if I had it. You know, other than spending it. I actually never really cared about luxury items, I just wanted to not have to work. I wanted money because that meant leisure.
So when I got into the world of trading my goal was to just make so much money that I didn’t have to think about money. I’d rather not spend my time thinking about money and that’s pretty true today as well. And even when I started making money, I always had a good excuse to not think about investing. For example, I wanted to buy a house as the conventional script says that’s what’s next. While saving for a downpayment you don’t consider risking those funds in the market, which of course is a good lesson right there. Even when you get to investing, a healthy goal is liability matching. You want to save for your kid’s college or a downpayment or retirement. The timeline of each of these dictates a different risk tolerance. If I need ransom money by Friday it’s risky to NOT go bet everything on black in Las Vegas.
When I got into trading it was as a market-maker. So I was the house. The bookie. Being on that side of the business, taking the other side of people’s hunches and opinions actually makes you think that investing is a mug’s game (at least if you were a hedgehog like me, who failed to see the broader picture). Eventually, as I matured, two things happened:
I had investable assets even after owning a home (actually after upgrading a few homes). So I started to feel that cash is not a good way to store value. Then I was like, oh, that’s why people invest. Some people actually have extra money. I know it sounds stupid, but I was really not someone interested in investing. I liked the game of trading and the business of making money by playing what felt like a game. But investing felt like something I had no expertise in so in that world I’m a tourist. I would need to start learning about investing.
When I went from being a Market Maker to becoming a Portfolio Manager at a volatility hedge fund that had clients I started to understand the world more realistically. When you are a market maker, you are putting up 100% returns on small capital. At a hedge fund, you slide down the alpha/capacity continuum. Then I realized that trading is a business and not an investing strategy, instead of thinking they were the same and that I was just on the smart side of investing. Now I realized that trading’s outsized return was compensation for doing a bunch of difficult things just as a restaurant needs to bring together many activities (procurement, hiring, cooking, serving, billing, etc) to make money. So if you are going to invest in secondary markets of course the returns would be lower. You weren’t running a business, you were just harvesting risk premiums that were set by an auction. That auction is the collective forecast of many smart investors minus a risk premium. And that’s ok. The flipside is you weren’t doing the work of a trading firm or restaurant to access it.
I went to the internet around 2016 to learn about investing AFTER having been a trader for 16 years.
Sitting here now, my core belief is that money is just a means to an end and not an end in itself. I don’t care if I beat markets as long as I can accomplish my goals. Savings and investments are for maintaining wealth you’ve earned, but human capital is how you get rich or earn. And compounding is a critical lesson to learn when you are young. Not understanding investing while sitting on savings was a costly mistake. (Although dwelling on that is silly…if I lived in Japan not investing would have been wise but the point is that you should learn about investing to understand the larger issue that wealth stored in cash decays so you need a plan for having your savings match your future expenses).
I discuss these topics further in:
My Investing Shame Is Your Gain
How I Misapplied My Trader Mindset To Investing
How to make better decisions: A crash course
MS: One thing that Naval said stuck with me: The most profound philosophers are the ones who have dedicated enough time to a craft or skill that they are able to view life through that lens. Buffett and Munger give a lot of investing metaphors that are equally applicable to life. Martial artists talk about life in fighting jargon. I’ve noticed that even when you write about non-financial topics, like designing your life or finding meaning, you use options jargon like Calls and Puts and Deltas and it totally makes sense.
How has trading options shaped your perspective on life? Has it given you an extra set of tools to think about life/investing/decision-making in a different way?
Kris: The answer to this is a resounding yes. Now the founder of SIG, Jeff Yass, has a very strong form expression of this when he says you can’t understand decision-making without understanding options. I think if you view this narrowly where “options” = financial options it’s a stretch. But Jeff and interestingly both Buffett and Munger admit to having thought deeply about options as early teens.
I don’t advocate for everyone to rush out and learn about calls and puts as a means to learn about decision-making but I do believe that thinking about risk and second-order effects is critical to making good choices. So to that end, I suspect the tip of the spear in understanding decision-making is likely proprietary trading firms who have massive sample sizes and feedback to learn from, and the military. (I’d like to throw doctors in this mix but my 10,000 ft view is that doctors are probably undertrained in this regard).
Circling back to what we can extract, I think of 2 categories: Object level or mechanical inputs into decision-making and meta-level. In a poker analogy these would map to:
1. Playing your cards
2. Playing your opponents
Playing your cards
This is understanding probability and the concept of edge. What are my odds of winning this hand with KK suited in a heads-up (ie 1 on 1) hand vs a multi-way pot (say 5 players)?
Extrapolating to decision-making in life, you need to consider what the distribution of a decision looks like: is it a normal curve or is it highly skewed? For example, if you are deciding what time to leave the house to make an appointment, the expected value might be 15 minutes, but there’s a lot of skew. A traffic jam could make it 30 minutes but there’s no way it will ever be 0 minutes. The same applies to investing sometimes.
An example that is highly direct to understanding options is being able to evaluate them in real life. For example, I wrote a post about car leases to help people appreciate the lease vs buy decision. This is a more straightforward calculation than understanding, say, the option of renting a home vs buying which has a harder-to-handicap variable.
Another example is what I call repeated game thinking which comes directly from the idea of edge and expected value. If I have a ⅔ chance of winning a bet but I have to lay 4-1 odds on any one trial, I’m likely to win. But in the long run, this is a losing game. So you want to convert the edge into a per-trial expectancy. In life, this is the same as good habits. Eating a donut once is fine, but as a habit, you are asking for health problems.
Understanding edge helps you think long-term. When I buy a lotto ticket, it doesn't cost me $2. It costs me $2 x the number of times I will do this because I’ve given myself permission to think of this as a one-off decision even though it’s not. Wearing a seatbelt, buying vitamins or interventions when you can’t tell if they actually do anything, the list goes on.
Playing your opponents
Betting is incremental information. And bets themselves say something truthful or deceptive. Narrowing the opponent’s hand based on their betting history and current pattern requires a mix of memory, a tree of deduction, and an understanding of their psychology which may take in external factors such as how tired they are, how much bankroll they have left, etc.
Extrapolating to real life, there are so many market concepts that summarize the behavior of groups that are viscerally felt in trading and can be safely extended to the wild. These include:
Market efficiency: If a market is widely accessible, transparent, and made up of a diverse group of actors then the consensus price it generates will be “fair” in that it incorporates all relevant information including information you don’t directly possess. For example, if you browse Zillow and see a house that looks like a great bargain, your instinct should be – something is wrong with that house (foundation, freeway noise, etc. Something you can’t see in the listing) not that you are the only person seeing a deal on something that is publicly visible on a Multiple Listing Service.
Avoiding adverse selection is as simple as asking – why am I getting a look at this? Have smart people had a chance to see this before me and passed? Trading hones this adversarial instinct.
Continuing with market efficiency is the appreciation for “wisdom of the crowds”. If a CEO says she’s stepping down I don’t assume this is bad for the stock. I just go look at the price and that tells me what the market thinks. Maybe it’s good news and the stock has been weighed down by this CEO. If an NFL player gets hurt mid-week I don’t need to wonder how bad this is for the team – I just look at how the line moved. It’s a good habit to outsource a lot of judgments to the wisdom of crowds or the “outside” view so you can focus on decisions where your judgment has more bearing.
MS: But surely the wisdom of crowds can go wrong, can’t it? How do you identify this?
Kris: Two interesting ways the wisdom of crowds turns into the madness of crowds are bubbles and perverse incentives. Both work by homogenizing the crowd (the wisdom of crowds depends on diverse actors who all bring a bit of useful information to the mosaic). The reason for the homogenization of a crowd is a big topic (Minsky is a great reference for this) and perverse incentives come from overly narrow values or poorly constructed rules. Goodhart’s law of when the measure becomes a target is embodied by the “cobra” parable. A govt in India offered a bounty on cobras to prevent overpopulation. The result: people started breeding cobras to kill them. If you think abstractly, this is not unlike a bubble – the output gets recycled as an input leading to a reinforcing loop.
Option Greeks, Convexity, and decision-making
MS: Do option “Greeks” have anything to teach the average person as well?
Kris: Of course. Consider option “greeks” like delta and vega. These are simply ratios or sensitivities which tell us how much an option’s price will change based on variables. Delta tells us how much an option price changes with respect to the stock price. It depends on the “moneyness” or how far the stock is from the strike price. This concept maps to real life as well. What’s the delta of a company’s value with respect to its costs? Think of an oil company, when oil is trading at a lower price than its cost to drill. That company’s value is pure extrinsic value. It’s an out-of-the-money call option. Think of the idea of Greeks in tech. SaaS companies have low marginal costs for serving their next customer so their unit economics or margins are amazing. Think of how its Greeks look compared to a service business where the economies of scale are not as attractive.
There are second-order greeks as well. Gamma is the change in delta vs the change in the stock price. This maps to acceleration and velocity in physics. You can’t estimate the final destination of a car in 1 hour if you just took a snapshot of velocity 30 seconds into the journey…you need to know what the acceleration curve looks like. And curve is the key word because acceleration is non-linear and leads to convexity.
MS: What is convexity? Why is it important?
Kris: In simple words, convexity is when values at the extremes, with low probability of happening, cannot be predicted from the average trend. Convexity wreaks havoc on estimates that linearly interpolate. That’s exactly why compounding is so unintuitive - you don’t see results for years on end, but once the returns start accumulating, the growth is exponential!
An investing example could be: Thinking that a stock is cheap because it appears to have a large runway (the cashburn measured in months or years). But what is the change in the cash burn if the economy gets weaker? If revenues fall, the net cashburn accelerates and the runway shrinks faster than what the snapshot predicted. Chain reactions are not captured in linear estimates.
For more on curves, see:
Where Does convexity Come From?
Greeks Are Everywhere
Moontower on Gamma
Options trading: An inside look
MS: What do most people miss about options trading when looking at it from the outside? What is the real difference between investing and trading?
Kris: Finally, options trading is a business, not quite an investment strategy. You invest IN businesses. The distinction is subtle but important. Trading is shorter-term in nature – the feedback loops are tighter, and there are endpoints in the form of catalysts and expirations, where convergence between price and reality occurs. You win a tournament, you take the profits off the table. You hunt for a new bet. In fact, that's why I like futures and options...they expire - which is a pre-determined catalyst for convergence.
Stocks are perpetual, and investing is really about re-investing. That’s how you compound. (In fact, Another way to think of a cheap stock: the market thinks the company will have a low return on invested capital?...the market discounts windfalls that won’t recur, and in its own language actually thinks about return per trial!)
I marry the two concepts by remembering that trading is a service to provide liquidity. There’s a mismatch in risk tolerance and horizon between buyers and sellers. Traders basically broker that. You can think of investing similarly if you think of your role as supplying liquidity to an unbalanced market preference and earning a risk premia for that job.2
MS: Continuing with that question, I want to examine how interest in derivatives has exploded in the last few years - Gamestop, AMC, Wallstreetbets, Crypto derivatives, etc. come to mind. Some of that might have even given options a bad name (?). Should everyone learn a little about options and how they work even if they never intend to use them?
Kris: Depends on the context. With options, you can speculate or hedge. When you use options, you are highly levered to specific outcomes (i.e how much will X move in some specified time frame). The bad news is you can be generally right but specifically wrong. For example, buying an OTM call, watching the stock increase but fall short of the exact strike you picked. That’s brutal.
The good news is you can use options to quarantine your risk, and only for a specific outcome. Just as term-life is cheaper than whole life. I generally recommend term-life because it solves a specific risk (“supporting my family until my kids are out of college in case something happens to me in the next 20 years”). So you can fine-tune or target your hedge and not pay for scenarios you aren’t worried about.
Because of this, using options as trade expressions forces you to tighten your thinking around the timing and potential return distributions of your thesis. So overall, I think learning options forces you to think better. The flip side is you become a degenerate gambler in a casino with an expensive vig3.
You should be meta about why you want to learn options in the first place so you don’t accidentally drift into degeneracy.4
Understanding put-call parity would help you understand that selling covered calls is equivalent to a short put and in general, show you that options are about volatility regardless of whether you use calls or puts. See:
What Part Of Selling Calls Is “Income”?
Selling Calls: It Might Be Passive, But It Ain’t Income
MS: What can index investors or value investors learn from the world of options to augment their own money management?
Kris: The specificity of options requires users to be rigorous about their bet expressions and the basis risk between the idea coming true and actually making money.
For index investors, they can be aware of the proposition they are signing up for. In today’s world, the implied earnings risk premium in the SPX is about 4% (Aswath Damodaran updates this quarterly at least). So a passive equity investor is signing up for a proposition that offers 4% over the Risk-Free Rate with about 20% volatility and fat tails (meaning large drawdowns occur more often than a normal distribution would suggest. In fact, we can look at an option surface for the outside view of how likely say a 25% selloff is in one year).
Overall, it’s not a very attractive proposition compared to history but everything is relative to the opportunities that currently exist. You can use the risk/reward of the proposition to modulate your sizing (one could argue that this is timing) but I’m answering this question for value investors who presumably start with valuation (as opposed to say a momentum investor).
Starting with Options from scratch
MS: If Wallstreetbets has given a very sleazy shade to the world of options, what’s a healthier, more disciplined way of approaching options?
Kris: Understand your goal first. Is it to hedge, speculate on specific outcomes, or vol trade?
For speculating, read the below first. One of the key takeaways is: for directional trading, 90% of the work happens upstream from the options i.e fundamental analysis, etc. It’s the fundamental work of handicapping the distribution. If you can do that, then comparing the option prices to your own assessment is a reasonably mechanical exercise - hence why it’s a small percent of the meaningful work. See: Structuring Directional Option Trades and How Options Confuse Directional Traders
For hedging, again there’s work upstream. Are you sure that hedging is the answer instead of just shrinking your trade size or diversifying more broadly? If you want to be rigorous about this question this post will give you the mental framework: If You Make Money Every Day You’re Not Maximizing
For vol trading: Don’t bother. It’s low margin, requires institutional cost structure and infrastructure, and detailed diversification. Hedging a market neutral book needs economies of scale. An analogy would be – AMZN wouldn’t have developed AWS if it didn’t need to be its first client.
Appreciate explicit vs implicit cost.
“Explicit cost of trading options is the transaction fees. RobinHood makes them zero to trick you. The implicit costs are what should concern you. Optically it looks cheap to trade options but you will chop yourself to pieces without clear objectives and plans. It’s tempting to sling them.
A 1% edge in a stock or ETF is enormous. Imagine buying a stock that was trading “fair” for $50 for $49.50. This is an order of magnitude more edge than HFTs earn. Hold my beer now as we do options. If the fair price for a call or put is $.50 and the bid/ask is $.49-.$51, you are giving up 2% edge every time you hit or lift. Before fees!
Option prices themselves are more volatile than the underlying stock so from the market-maker’s perspective the Sharpe of the trade might be pretty small (getting 2% edge on a security that might have a 100% vol for example). But think of the second-order effect…the optical tightness of the market and high volatility of option prices means it can take many trades before the option tourist realizes just how much the deck is stacked against them.
For independent market-makers, like I was 10 years ago, the tight markets made our business worse because our risk and capital limits did not allow us to keep pace with the volume scaling required to make up for the smaller edge per trade. But the large market-makers welcomed the increased transparency and liquidity because they could leverage their infrastructure effectively.If you make a 50/50 bet with a bookie but need to pay them 105 to 100 you are giving up 2.5% per bet (imagine you win one and lose one…you are down 5% after 2 bets). Now think of a vertical spread or risk reversal in the options market. Pay up a nickel on a $2 spread? Might as well have a bookie on speed dial.”
MS: Where should a complete beginner to Options start and with what mindset?
Kris: For options, the Moontower Option’s Wiki is a one-stop-shop. Totally free resource:
The Options Starter Pack
For mindset: be realistic about your goals. Your goals inform the strategy. Are you trying to grow savings to match liabilities, get rich or something in the middle?
If you just want to tinker, don’t play with money you can’t lose. Journal about what you do – create speedbumps for yourself. It’s very convenient to trade options, which masks the danger of what you are doing.
Seek help from others who aren’t invested in you churning
Now if you want to be an active trader and have it be worth your time you will need to bring a lunch pail and a professional mindset. I discourage this generally but if you are determined these are the best interviews I’ve seen on the topic:
How To Turn Pro As A Trader
Specifically, go to 1:15:30 and listen for 2.5 minutes. This episode is the best dose of reality/debunking. It's simultaneously encouraging and discouraging. If you read between the lines it's saying there are lots of ways to make money. Some are being AMZN and some are possible as a small player.
The formula is you have to work very hard either to figure things out or to get into a firm that can teach you. And you have to be smart. The competitive nature of this business comes through strongly. You will also need people skills so in that sense it's like any business. And there's definitely no magic formula.Finally, remember that the mark of a professional is self-evaluation and measurement. If athletes didn’t watch film, they wouldn’t learn. It’s hard work to go back and dissect what you did wrong. We all just want to go forward. If a runner never timed (ie measured) themselves and experimented methodically with training, they’d never get better. Being an active or professional investor is no different. See: Being a Pro And Permission To Be Serious
MS: Is there any insight that you gained by being in the thick of the options trading market, witnessing thousands of transactions over the years, seeing how institutions operate, that individual investors have no idea about?
Kris: There is no magic formula. It’s not some hidden bit of IP that makes firms profitable. It’s the ability to be a chef, combine ingredients, and execute. The most important things for survival are mundane. This means the mundane is the priority – catching trading errors, communicating effectively, monitoring risk.
In the next part, Kris dives deeper into how long-term investors can educate themselves, his insights from the legendary trader training program at Susquehanna, and much more! Stay tuned for next week’s issue.
Part 2 is out! You can read it here.
Kris’s blog Moontower Meta is named after the moontower from Dazed and Confused - The same movie in which Matthew McConnaughey debuted with his signature catchphrase.
I liken the investor to the casino or the “house” here (at a different layer of abstraction – the execution level – the intermediaries are the casino but I digress). See: On Having An Edge
vig is short for vigorish, or the cut you have to pay to the casino (or the market makers in this case) from your winnings.
Apologies to anyone from r/wallstreetbets reading this.