I graduated in 2000. It was the height of dot-com mania. I took a job with Susquehanna, one of the largest derivatives trading market-makers in the world. My first year as a clerk was a rotation through different rings¹ on the American Stock Exchange. I learned to trade ETFs, equity options, and index options. After a year, I was off to spend 3 months at the mother ship studying theory and mock-trading in the physical pit they fashioned in a conference room. I still refer to my ragged notebook from those sessions to write my options theory blog posts.
Susquehanna is rightfully famous for its trader education program. It is an enormous source of edge to them. They ask you to sign a 3-year non-compete after the training ends to secure your job as a full-time trader with your own p/l. While I resented the non-compete at the time, I think it was a good trade in hindsight. I got an amazing experience at a young age. The firm’s way of thinking about risk and reward is recognizable to anybody that emerged from its deep-rooted culture.
But there’s a twist. A darker angle that I have been reflecting on.
The four-letter version of culture is cult. You see, Susquehanna had (I’d say “has” but I am a generation removed from the firm and this post is really about me not them) a tangible culture. Today, living near Silicon Valley, culture is discussed a lot. I’ve heard it described as “what you reward and what you punish”. Susq had a distinctly strong culture, but since I was young and impressionable, I had a cultish adherence to it. The downside of a strong culture, is a weaker mind will overinternalize it. That was me. Plenty of traders were able to take the best of the culture without overgeneralizing it to life. I missed the memo to not take it too seriously.
This post is about how I misapplied the lessons of my trading career to my investing life.
Mother’s Milk
Indoctrination started as early as the interview process. You witness Susquehanna’s preference for using games, especially poker to teach “decision-making under uncertainty.”² Games are closed systems. Taleb warns of “ludic fallacies” in trying to transfer lessons from games to markets. Still, there are enough parallels that an elite trading firm that has trained countless recruits deems the poker table a timeless professor.³ Using pot odds to compute risk/reward, Bayesian thinking to narrow competitors hands, seating position to calibrate possible starting hands. Then there were meta lessons. Who’s the fish? The sharps’ job is not to play against one another but extract the dead money. This takes self-awareness. It requires balancing the confidence to act when you have the edge vs the risk of overconfidence when imagining yourself in the pecking order.
To a young mind, sorting the world to organize the immense amount of info that was coming at me professionally, I started to form heuristics. Taken too far, these heuristics would become oversimplifications when extended to investing. I’ll give 2 examples of how I reduced my environment.
1. Zero-Sum Edge
Strictly speaking, options trading is zero-sum. Sure, it’s possible that if you buy call options from me, and I hedge them, that we both win. But in that case, the counterparties I hedged my option deltas with lost. The p/l reflects the transfer of risk and the total risk is conserved. Markets generate prices. Prices facilitate the flow of risk from those who do not want to hold a risk to those that do in search of expected profit.
As derivatives market-makers, the most adaptive starting point to isolate the mathematical edge is to assume the underlying stocks were fairly priced. I traded MSFT options for a few years. I never had an opinion on MSFT stock price. I figured there are thousands of smart, informed investors duking it out to set its price. From my seat at the table, the point spread incorporated all substantive information. But in the small arena of vol intelligence, I could have an edge. That was our expertise.
Building on this zero-sum world, our edge was just a casino vig. Without tourists punting on earnings or hedging, there was no business. We were not interested in giving the card-counters or informed counterparties action. A large focus of the job was to discern toxic from benign flow (I’ve written about how this is the entire basis of payment for order flow). In fact, when we identified the sharps we tried to bet with them. Likewise, if we isolated benign customers we thought about how to maximize their LTV by trying to price more tightly and have them coming back to us. In this case, the casino host is a fitting if dim analogy.
The focus on who the customer is permeated every decision. If a customer quoted a risk reversal (a spread between a put and a call on different OTM strikes) we’d typically lean the market as if they were going to be a buyer of the put. Why? Think of a simple decision tree. If the customer is a buyer of the put they could be informed about an upcoming negative catalyst, but there’s also a large chance they are hedging by collaring their stock. A hedge is benign. We might not even hedge the Greeks it saddled us with (hedging is the cost of reducing risk, so if the risk was not outsize to our substantial capital AND we didn’t think the trade had any information in it, we wouldn’t hedge. The accumulated delta risks were best aggregated at the firm level for centralized hedging). However, if the customer, bought calls the probability that they were “smart” is much higher since they are probably not hedging but speculating. We might even overhedge while trying to do as little size as possible on our wrongly leaned bid/ask.
Over and over we obsessed over who we were trading with. You’d just start filing “paper” (lingo for customers) as “smart” or benign (a more colorful expression would be “donkey”). Of course, they were playing a different game and the execution edge they were giving up was the cost of doing business. But 20 years ago, you could drive a truck full of money through the wide bid/offer spreads. Any uninformed trader using the options market was facing a vig so large that their returns were doomed if they kept coming back. And many customers did go out of business as surely as our profits grew (if you are unconvinced see Understanding Edge).
I came to believe edge was only possible on short cycles. Large sample sizes and frequent trading would quickly reveal if you had one. How could you trust stock pickers with their small sample sizes and inability to validate statistical edge? I generalized a useful assumption, “the stock is fairly priced”, as gospel truth. This made me agnostic about what I was trading. Everything was just a number on a screen. A video game. Only the flows mattered. Only the patterns of buying and selling. Asset managers focused on fundamentals were tourists with elaborate stories and fancy suits.
2. Other People’s Money
Speaking of asset managers, my view of funds was especially dark. It still kinda is. I’ve written:
Asset management is the vitamin industry. It sells noise as signal. It sells placebos. There will always be one edge that never goes out of style — marketing.
Working for a firm that had no outside capital and made profits consistently, the idea of earning single-digit returns or even losing looked idiotic. Why bother? Firms with provable edges don’t try to raise money. If it’s provable it does not need more eyeballs on it. In my view, the adverse selection of being able to invest in a fund mirrored the adversity of getting filled on a highly competitive price you made. It’s the Groucho Marx thing — “I refuse to join any club that would have me as a member.” It didn’t help that my girlfriend (now wife) would take me to her holiday parties with the Greenwich crowd where I’d always remember some overconfident hedgie craft some vision of the world. I remember one encounter with a partner who said I “looked like a trader”. WTF? (With the benefit of maturity, my insecure impulse to want to pound him was super cringe. Thanks for reading my self-therapy).
The biggest indignity came when I interviewed for an execution trader job at a famous long/short fund. I had an especially warm intro to this firm. It was the heydey of hedge funds and they had no clue how to price comp. The position would have doubled my pay. Unfortunately, I was rejected after a very strong interview with the head trader. Backchanneling, the feedback was “You would have been bored”. This single data point solidified my feeling that these overfed funds were dog-and-pony shows. (From what you can tell of my awareness skills at this point, you agree, it couldn’t have been me right? Umm, right?!)
What I Was Thinking
I’m a decade into my career.
I don’t believe anyone except the house could have an edge. I have still given no thought to personal investing. I followed the society script of saving for a condo. In the first decade of my career, I witnessed the dot-com crash, 9/11, and the Great Financial Crisis in the wake of subprime defaults. Markets were nothing but pump and dumps. Investing was astrology.
Trading was different.
Market-making was a picks and shovel business. The job was to find prices that cannot simultaneously be true. “I’m sellling this here because I can buy this here.” And those things need to have a real, almost arbitrage, relationship between each other. A short wire between them, for example, a simple call spread. Sure, real investors claim they do this on longer timelines, where the disparities are greater, but so is the length of the wire between the 2 ideas. You’d have to pull one thing so far to exhaust the slack in the wire. In the meantime, you were collecting that 2% management fee and long a performance call. This looked like a racket to me.
For my thinking to evolve, I needed a mutation.
Maturing
In 2012, I moved to SF become a portfolio manager at a vol-focused hedge fund. My journey through market-making took me into several option markets including energy, softs, ags, and precious metals. I used to bounce around trading pits as a member of all three exchanges⁴ in the Nymex building. Now, it was time to take a bird’s eye seat and move up the edge/capacity continuum. If you were willing to accept a worse risk/reward, you could increase capacity. And this made sense. The economics would need to flip. Instead of me earning 70% of my profits (I had a backer in my independent years after leaving Susq in 2008), I would earn a smaller cut of a bigger pie so the investors would receive most of the edge.
Can you believe it? A fund could be a win-win solution to a customer’s needs. It only took me a decade of unwavering skepticism (a total affront to my wife by the way who has been on the buy-side for the better part of 20 years).
From this seat, I learned the more formal language of investing and finance. I learned how allocators thought about correlations and diversification. I learned how they thought about liabilities and what they considered to be risk. I then started to lurk on Twitter. I learned that Michael Mauboussin has written about everything I was taught about trading. He just did it from a skyscraper, instead of on a broker’s buy/sell pad. I learned that what I called edge was called alpha. I learned how beta was a form of risk premia levered to growth. So returns didn’t occur because stock prices “just go up”. Returns come from the economy growing and earnings going up. The transmission mechanism to stocks was still very noisy. But it’s less noisy in the long term (assuming the economy is growing).
In short, while trading is a zero-sum game, investing is not!
Zero-sum Thinking Is Naturally Short Term
The major mistake of my trading mindset is how short-term it oriented me.
- I failed to appreciate compounding
Trading businesses are capacity constrained. The partners at Susq were plowing money into technology and growing the business. I remember feeling betrayed when they started hiring salespeople and analysts. We were a trader-first firm but now we were being asked to cooperate with the types of people I considered showmen and dumb flow. Instead, I was missing the broad view. Susq needed to deploy their rapidly increasing capital. That would mean building out a sell-side business, but it later would mean developing fundamental views. The idea that “stocks are fairly” priced would remain useful for option traders, but was Susq going to just dump any excess money into Vanguard funds? No, they were going to figure out stock-picking. The world of trading is not investing. The bets have endpoints. You win a tournament, you take the profits off the table. You hunt for a new bet.
But investing is about re-investing. That’s how you compound. - Taxes
I’ve lived in the highest tax domiciles in the US and have been paid on a W2 my whole career. The ratio of my earnings and lifetime p/l to my wealth is embarrassing. Part of the trading mentality is short-termism. Today I’m thinking more about bets that pay off longer in the future. Bets that build under the surface, accumulating value. Value that is not marked and therefore untaxed. Human capital works that way. Ownership often works that way.
Sure, a mercenary mindset can be worth it. But just as a ballplayer needs to earn a giant 1 year-deal to make it appetizing relative to a longer-term contract, you must be thoughtful about how you align your rewards with your efforts. Short-term certainty creates reinvestment risk. Weigh them carefully.
Combining Influences
I’m deeply grateful for the lessons trading and Susq taught me. I’m disappointed in how I misapplied them. That’s on me. There were others who sat in on the same classes and were not as slavish or myopic.
The experience on the buy-side, meeting people on Twitter, and being a better listener has been a revelation. When I combine these influences with my trading experience I have incorporated the following thoughts about investing:
- At a high level, I focus on asset allocation.
Risk and correlation are my primary concerns. Focus on the shape of returns and how the systemic risks you are underwriting are correlated to each other. Do this qualitatively. For example, I think of real estate as an idiosyncratic risk based on local supply/demand, but its systematic risks are interest rates and liquidity.
Presume returns will be driven by market-implied parameters. This is the agnostic part I accept from trading. If you invest in large-cap US equities today, they offer say a 3-4% risk premia over the risk-free rate, in exchange for 20% volatility and fat tails. It’s not a great proposition, but the point is I don’t pretend I would get more out of my equity allocation. Size that proposition appropriately. - Taxes
Put high turnover or income-producing investments in tax-advantaged accounts. Use ETFs over mutual funds in taxable accounts. - Default to passive if not looking at a niche strategy
Passive allocation allows you to draft on the increasing efficiency of markets and not pay too much in fees. - Private investments
I appreciate that people can find an edge in their respective domains. I was spoiled by trading. Expiration cycles, large sample size, and a lack of beta meant edge, positive or negative, reveal you faster.
Investing is a more wicked domain. My default belief is still that edge is rare and mostly unavailable to me. Storytellers can hide in the randomness and low signal-to-noise. And I’m not fully immune from them anyway.
Still, I believe if you filter well, the number of times you get burned will just be the cost of doing business. Any private investment has to satisfy my doubt as to why I should be invited. And once invited, I am mostly judging character and ability. This is admittedly an act of faith. I’m pattern-matching to successful traders I’ve seen. I’m comfortable betting on people. Not because I even know if I am good at this, but because I think there are more ways to fail forward. If I constrain my risks at the sizing level I can more easily enjoy the positivity that emerges from partnering, helping, and believing in one another. It’s more holistic than a spreadsheet.
In a recent interview with Meb Faber, Ted Seides articulated my wife and my feelings exactly:
Most of the [private] investments are actually people that I’ve known for a long time. I don’t have investments with the big brand-name people. And part of that, for me, there’s an angle on active management, and certainly, this style of active management that I think is completely lost in the active-passive debate, which is the relationship aspect of it. Because I can give money to a manager, and yes, I will get the returns that come from that, but who knows what else is going to happen, both potentially financially and also just in life, right?
There’s so much optionality that comes from having great relationships with people. It’s one of the reasons why it was easy for me to have a bias towards sticking with managers. I can’t stand ending those relationships with people I respect and think are smart. And I’ll happily, like, take a little bit of a financial hit in the short term if I think it’ll keep going for the long term.
Wrapping Up
There are many ways you can apply the lessons of trading to life. There are adaptive ways to apply options reasoning to other domains. You can also live a totally unexciting life of collecting options⁵ but not exercising any.
Knowing when to apply analogies is an art that requires choosing pertinent references classes and having awareness of what actually matters⁶. We are at the mercy of initial conditions, frames, and contexts. You have blindspots coming from your training as surely as they come from the womb. The trading business smells so much like investing that I confused zero-sum with positive-sum because the wrapping looked the same.
Seinfeld said “Pain is knowledge rushing in to fill a gap. When you stub your toe on the foot of the bed, that was a gap in knowledge. And the pain is a lot of information really quick.” The pain of lagging a bull market made me examine my lack of emphasis on investing (As traders say, “nothing like price to change sentiment”). With more personal capital and years removed from 2 market crashes, I came to realize I should pay more attention to investing. As I examined how institutional allocators think about their goals and liabilities, I realized I should think longer-term. It’s why I came to Twitter. To plug into broader learning and more ways of thought.
Investing is a rich topic because the longer-term orientation forces you to learn more about yourself. You question your objectives and risk tolerance. You question what you know and how you came to know it. In that sense, investing is deeply about people and growth. It’s a conclusion I never could have imagined when I was bum-hunting on the trading floor.
Footnotes
- The AMEX was a specialist system as opposed to the “open outcry” pits Chicago or on the NYMEX. On the AMEX the pits were more commonly referred to as “rings” or “crowds”
- Check out their gaming blog RaiseYourGame.com
- In the 3-month trading class, every trainee needed to log 100 hours of seven-card stud. As times changed, the game became Texas Hold Em, but in my year it was still stud.
- Nymex, Comex, ICE (formerly NYBOT)
- See The Option Cage
- See my summary of Mauboussin's Making Better Comparisons