Yesterday Andrew Mack and Euan Sinclair dropped their new book Retail Options Trading.
If you are interested in the topic don't even hesitate, lift it, start reading while you’re at work.
I actually read it twice.
How?
I had an early copy.
Why?
Because I had the insane privilege of writing the foreword. Both of these guys have published multiple books. Andrew’s specialty is sports betting and modeling and Euan is the GOAT of option authors. I ain’t published diddly squat in the physical world so to be asked to intro this opus, a book that is immediate canon, was a massive honor.
With permission, today’s Moontower is the foreword to Retail Options Trading.
And again…buy the book. For you. As gifts for others. For your mother’s stocking. For the cat.
Moontower Foreword to Retail Option Trading
The book in your hand holds the map to treasure.
Maps, themselves, don’t take you to the bounty. They point you in the direction, but they don’t traverse the terrain for you. If you want to trade options seriously it’s going to take effort. As a serious adult picking up a book about options, you already expected this.
Looking at the landscape of books aimed at retail traders, I’ll predict that you did not expect anything else that this book is about to do for you. It will redefine your understanding of what trading is. It is a complete upgrade of your mental operating system. You are learning a new language that shapes all downstream decision making – from how you think about prospecting for opportunity to managing risk.
It’s not the dialect of chartists or MBAs. It’s certainly not the bloated exclamatory language of house-flipping seminar grifters that have set their sights on the retail options world. This is the language of advantage gamblers. The sharps. The private prop trading firms and market makers. The house.
It sounds like a stretch for a 300 page book, doesn’t it? I’m going to borrow a few of those pages to prove it. If you’re reading this, you probably own the book. This isn’t about convincing you to buy it. It is convincing you to use it.
This is not a novel. It’s a manual. The proper way to read this book is with an active mind. The book teaches you where to look for profitable questions and gives you the tools for testing them.
Let’s warm up that active mind.
The Riddle of The Corrupt Casino
You’re in Vegas for a weekend of good food and to catch a show at the Sphere (this is either what it means to visit Vegas in the year 2024 or a confession of my banal midlife groove).
You notice that new coin-flipping game the casino has been touting as a fair deal. It’s the first day it’s been on the floor.
It’s super simple. If you flip heads you win the amount of your bet, tails you lose your bet. So if you bet $1 you will either win an additional dollar so you have 1 more than you started with or lose your dollar.
You are getting a the fair 1-1 payoff on an even proposition.
The casino claims the increased traffic pays off at the restaurants and hotel rooms so the coin game can justify its spot on the floor even without being a profit center on its own merit.
You eagerly accept this pitch. You already play other casino games and figure you’re better off satisfying your need for action by playing this fairly priced game.
You decide to bet 1% of your bankroll per trial. You read a book by an option guy named Euan before and remembered someone named Kelly who recommended betting a fraction of your bankroll. You can’t recall remember the details but figure 1% bets with a balanced game and you’ll be able to play for hours while sipping Cuba libres. They’re watered down, but so what? They’re free.
Here’s the rub. The casino is shady. The coin is rigged. Depending on the exact table, the coin is either 90% to land tails or 51% to land tails.
Which table will take 50% of your money first?
I’ll give you some time to think about it. We’ll revisit the question later.
You’re here to learn about trading not crooked make-believe casinos anyway.
What is Trading?
You picked up a book with “trading” in the title, so the word must occupy a semantic representation in your brain. Ask yourself to define to it. I’ll wait.
I’ve never polled an audience for their definition but I’d guess that the most common answers would strongly rhyme with “the act of buying and selling to make a profit”. Some clever cats might use say something a bit more sophisticated like “buying things below what their worth and selling things for more than what they’re worth in an expectation of profit”.
These are fine answers. Still, T the best answer would be a consistent, focused reminder of the nature of the activity. Let’s see if we can get there.
A great first step is to rule out what trading is not. Trading is NOT investing. To think they are the same is common and forgivable delusion. They both share a common language of risk and reward, they are both concerned with a profitable return, and the most blurring of lines – they are both performed in the same way – by clicking on a brokerage firm’s UI.
However, we also notice distinguishing features that suggest trading and investing are different. There are clues that they are different even though the features themselves are not the true source of the difference. A cat’s whiskers are a clue that they are different from dogs, but the whisker is not a defining delimiter.
The most powerful example of a distinguishing but non-defining difference between investing and trading is time horizon. Investments are typically held for long periods. Mechanically, this behavior is stimulated by the tax code via long-term capital gain treatment. But there must be more than that (especially since this hypothesis is undermined by the cult of dividend and cash-flow hogging).
You will struggle to name the “something more”. The word “compounding” will flash across your consciousness but this is just a mathematical description of growth. An argument for investing must address the source of return, not just its shape.
The rationale of long-term investing is a surprisingly (alarmingly?) faith-based exercise predicated on the expansion of prosperity. Real economic growth. That’s only one assumption. It also relies on public corporations maintaining an acceptable pro-rata take from that growth in the form of profit, and the persistence of governance norms whereby shareholders can lay claim to those earnings. If you’ve never thought of the layers of assumptions abstracted by the act of clicking “Buy SPY” I recommend explaining stock investing to a 4th grader.
We can contrast the basis of long-term investing with the shorter horizons in trading that are defined by convergence. Convergence can be an option expiration, the closing of a merger arbitrage situation, an oil future maturing to the prevailing spot price. The bill comes due after the meal and the table turns over to serve a new customer. In investing, the check eventually comes, but it can take a generation of layaway or credit extensions to resolve the truth.
But if trading is not investing, what is it?
Trading is a business itself. It’s not investing but something you can invest in.
The business of trading is getting paid for a service — namely to warehouse a risk that, on balance, the market does not want.
You aren’t reading this book because you are 501c with a mission to serve the market. You demand a fee, or what Euan and Andrew call edge.
Edge is the fee the market is willing to pay to offload the risk it doesn’t want. This “risk” is reflected in the clearing price after all buyers and sellers have met in the marketplace. If the buyers dominate, the prevailing price is bidding for sellers. If the sellers dominate, the price is advertising a bargain for buyers.
The trouble is that the financial markets are cagier than your local supermarket. You know when eggs are on sale. But in financial markets if a company’s earning report shows profits and forward guidance are both up substantially, and the stock only rallies 2%, then is the stock being bid, or is it actually for sale.? Which side is offering the edge and how much is it? By focusing on these questions, your trading mind graduates to a tier where success finally becomes a possibility.
The authors write:
[A trader’s] biggest error is not recognizing the primacy of edge. We can manage risk perfectly by not taking any positions. Edge is by far the most important thing…Edge is an unfair deal in our favor.
No edge, no business.
This book serves a singular objective — Find.The.Edge.
What you’ll find in the book
Euan and Andrew are not motivational speakers. They are practitioners. They immediately dispel rah-rah notions that anybody can manifest their way to becoming successful traders. You will quickly discover what they mean when they write:
“Trading is a performance-based activity. There are no cases of performance-based skills where amateurs have advantages over the professionals.”
Or the idea that “while the strong version of efficient markets hypothesis is surely false, its shortcomings are vastly outweighed by its utility in aiding our understanding.”
If you heard this at a pep rally you might start looking around the gym to make sure you were in the right place. But it makes the oxygen they pump in that much more effective:
“Viewed from an aggregate level, we see broad market efficiency - it is important to understand though that the probability of finding a useful market effect is not uniformly distributed - opportunities tend to be found clustered together in a small group of categories. Below we will discuss several areas where inefficiencies have been known to hide.”
They proceed to sort inefficiencies into a more functional, memorable expression of my trading vs investing distinction:
Anomalies versus risk premia.
Anomalies are hidden-to-the-naked-eye disturbances. They are signatures of risk-shuffling behavior. A plea for service
Risk premia are relatively durable opportunities are more resistant to decay because they aren’t a secret – but rather an uncomfortable risk to warehouse. The most obvious of such premia is the so-called equity risk premia which explains stock returns in excess of the risk-free rate as the carrot to entice people to invest despite significant risk of nominal losses. It’s a bit circular, but stocks offer excess returns because if they didn’t who would stick their neck out to buy them.
There is no mechanism for arbitraging this return out of the market. Risk premia trades have huge capacity, with plenty of room for everyone who wants to get involved.
Starting from the discussion of market efficiency as well as where it is likely to be violated to the taxonomy of efficiencies, you are given a clean mental bento box to neatly file the clinical essentials cataloged in the text.
These essentials include:
- A taxonomy of anomalies (examples include timing, sentiment, etc)
- Techniques for detecting non-random or abnormal behavior in data and the contexts in which they are best applied (Benford’s Law, Hurst exponents, decile sorts, Z-scores, etc)
- Sound practice (understanding why we use logreturns, or why and how to detrend realized volatility calculations)
In addition to the essentials, I found quite a surprise. A takedown of the rampant “psychology” emphasis in trading, followed by…a chapter on psychology that dominates almost everything that has likely been written on trading psychology in the way that a Draw Four dominates both a Draw 2 and a Wild. If you only read this chapter you’d feel you got your money’s worth.
Return to The Riddle of The Corrupt Casino
So which rigged coin-tossing game is going to cut your bankroll in half faster, the one where you have a 49% chance of tossing heads or the one where you only have a 10% chance of tossing heads?
It’s the 49% version.
This game only has a small negative edge. Small enough to hide. You don’t play games where it’s obvious you are being ripped off. You must think you have a chance, you must get enough positive feedback in the form of heads, to stay at the table.
Consider the path.
In the game where the coin is rigged to be tails 90% of the time, on average you will have lost 10% of your bankroll within 13 trials. To lose 10% of your money betting only 1% each time that quickly on a fair coin would be larger than a 3 standard deviation event. Even if you didn’t work out the math, you’ve been alive long enough to know that if you flip a coin 13 times and only saw 1 or 2 heads that you’ve been had.
In the long run, the 49% coin will take more money from you because the noise keeps your guard down.
I fashioned this riddle for 2 reasons.
The first is to reinforce the animating theme of the book – edge is the lifeblood of trading.
The late, great Charlie Munger advises, "Take a simple idea and take it seriously." My trading alma mater, SIG, is an embodiment of that quote. Paraphrasing its founder, the entire basis of the firm was the realization that as surely as a positive edge repeated many times will make you rich (assuming you don’t overbet), a negative one will drain you.
The second reason for the riddle is it requires second order thinking. A reader’s reflex is to think the 90% tails coin will claim your cash. But you’d need to consider the path to realize that it’s unlikely that anyone with common sense would play the game long enough with the hell coin to actually lose 50%. (There’s also the ricochet second order lesson – if I’m asking the question the obvious choice is probably wrong).
The importance of multi-order thinking is critical in trading because it’s not a physics problem. It’s a biology problem. Trading is an adversarial game that pushes back. Your opponents adapt. In sports-betting, it’s not enough to pick the winner, you have to beat the spread.
It’s no surprise that a book written by hybrid sports bettors/ traders, is bursting with second-order wisdom.
These are just a few of my favorite examples:
- In bubbles, it is often a good trade to make the “wrong” directional bet. In this example, we wanted to bet on UVXY going down. Level one thinking would have you buying puts (selling calls is clearly very high risk in these cases). But the better bet is to sell puts. If the bubble continues, the puts will get further away and will expire worthless. But if the bubble pops, the implied volatility will drop and your short vega from the puts will make money.
- Testing ideas that are easy, straightforward or inexpensive to investigate engages an observational bias known as the streetlight effect. "This barrier to entry creates information gaps that can present opportunities."…this caveat applied to timing anomalies: “we’re not the only one with a calendar”
- As traders we don’t want definitive proof. If something is statistically inarguable, it will have been noticed by others and probably coming to the end of its profitable life. I’ve written the same thing in the context of choosing investment managers. I call it the Paradox of Provable Alpha – any strategy that can be quantitatively proved dominant, think Renaissance Technologies, will not take your money, so your only hope in finding superior managers is in discretionary strategies requiring a leap of qualitative faith.
Perspective
Beyond the essentials, you will discover the rarest form of guidance – lessons in proportionality and perspective that hyper-experienced traders understand but are surprising to non-professionals. You are maximally forgiven for being surprised. Trading books are rife with banality. This book is armor against the fuzzy prescriptions littered across the trading literature.
Just consider the oft-repeated aphorism by Munger’s partner Warren Buffet.
“Rule number one: don’t lose money”
To be clear, Warren is a genius. But not for content of lines like that. Part of his genius is his disarming folksy persona. Don’t confuse his Mark-Twain level wit for a specific action. His “-isms” are optimized for virality not surgery.
Contrast his abstract advice against our authors’ prescriptions:
Insure yourself against catastrophe, not against a loss that is merely unpleasant. In this example, we are capping our loss at about 30 weeks of expected profits. That seems reasonable. Don’t cap losses at, for example, five times the expected profit. That is far too cautious. You don’t want the hedge to come into play often. It is to avert disaster, not to be a usual part of your strategy.
Capping risk to make yourself feel comfortable is a terrible idea. You can only collect a risk premium if you take risk. And the options you would need to buy to make yourself comfortable are probably the ones that have the highest risk premium. You have to be OK with losing. And not losses that are two or three times your expected win, but more like losses that are 20 times your expected win. Your average loss won’t be anywhere near this size, but you have to be prepared to suffer one of that size eventually. Note: maybe the most undersold truth in retail trading lore
There are so many hard-fought bits in this book that you usually don’t find written down or if you do they are hard to understand until you’ve had enough live fire. Some of my favorites include:
- Knowing about option Greeks won’t make you any money, but not knowing about them could lose you a lot.
- There are no bad positions, only positions you entered at a bad price.
- The incorrect way to reason now is to say, “what is the chance of SPY jumping 15% down?” When it comes to risk, don’t evaluate based on probability. Evaluate based on consequence. If SPY dropped to zero, this position would lose about $53,000. Could you survive that? Not “would you be unconcerned?” but “would you survive?”.
- Losing money on any particular trade isn’t risk. This is just a consequence of the probabilistic nature of trading.
- The edge here isn’t in the math (it never is). The edge is in knowing whether the stock will continue to trend (or not trend). [The context of this one is that many people understand that vol is underpriced in the presence of trend but they stop there and don’t cross the final bridge – the edge therefore has nothing to do with the options but in identifying if there’s a trend. This is not a micro distinction or semantic nitpick. It is fundamental to understanding the source of edge.]
- The myth of trading being a uniquely stressful job
- The misplaced obsession with market makers being out to get you. In fact, that section dovetails nicely with the implication of the corrupt casino riddle.
- Where perfection is helpful. And where it’s not.
- Why you should stop thinking about “taking profits”, “letting profits run” or “looking for an exit”. This section was one of my favorite because it tackles the widest delta between what pros know and what retail is told.
- The value of transposition & derivative logic. I’d guess at least half my lifetime earnings come from understanding these topics.
- Why option strategies are not “strategy”
In conversation with Euan and Andrew, we are strongly united by the idea that the upper tier of retail traders are underestimated. They are harder-working, necessarily clever, and far more resourceful than what most professionals will concede.
The waterline of high quality options knowledge in the retail world continues to rise quickly. If I’m in a self-flattering mood, I like to think I’ve had a role in that.
But it is indisputable that Euan and Andrew have been at the vanguard of spreading practical, professional mentorship to a dedicated band of retail traders who have enough awareness to cut their way thru the jungle of what-people-want-to-hear nonsense to find an authentic map to treasure.
I’m inspired. You will be too.
This is step one.
Get to work.