Brainstorms: Volatility, Academic Papers, AI Stocks

Are you giving the edge or taking the edge?

Hey everyone!

Hope you had a good weekend!

Going to cover several things today:

• Volatility

• Academic vs Praciticionair: Why do I read so many academic articles?

• AI Stocks

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Volatility and Leverage

A couple of articles back, I shared a synthesis of tweets that helped me tremendously in thinking about financial markets. Here is the original article:

There is one phrase I want to focus on:

Once you start to understand the two ideas in the quote above, you will begin to comprehend WHY financial markets function and HOW generating returns can even be possible.

What does this mean? On a very basic level, it means markets reward those who know how to benefit and thrive amidst volatility. This quote isn’t about how long you can endure a drawdown but about how to become a beneficiary of volatility as opposed to being crushed by it.

Volatility in markets is directly tied to liquidity as well as the time preferences and constraints of individual players. When you position yourself correctly in markets, volatility takes money from the weak and gives it to the strong. When you transact in any market on any time horizon, you are always either conceding the edge or taking the edge.

All of these ideas can be somewhat quantified when running strategies but there are still elements that always remain elusive, such as "more variance in the future than observed in the past." When you consider purely systematic funds or individuals who aren't good at envisaging a future different from the past, positioning begins to accumulate that will be flushed out when an "unpredictable event" occurs.

This idea of continuity and discontinuity from the past leads me to my next point which is, why do I read so many academic articles?

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Academic vs Praciticionair:

Someone recently asked me why I read so many SSRN academic papers when academics are often seen as impractical people with minimal experience in the real world. This is a great question, so let's break it down into a few parts:

• First, in any domain of life, there is competition. The academics criticize the practitioners for not understanding how things should actually work and the practitioners criticize the academics for not operating in the real world with risk. I simply see a silo of knowledge that people don’t want to cross because of their ego. If there aren't a ton of risk-takers reading academic literature, then that likely means I might find some information that they wouldn't think of. I am always trying to identify these silos of knowledge to find an edge.

• Second, I think about trading (and life) as identifying continuity and discontinuity with the past in order to connect the situation with a priori and a posteriori thinking. Put simply, if we are going through a market crash, then I want to read about every other market crash in history to identify the continuity. Academic literature is amazing at identifying continuity across time, even if it is backfitted sometimes.

• Third, more recently, a lot of good academic literature has been written by individuals who are actually taking risks at large funds. I have already shared some AQR research (link) with you, which is a firm that actively takes risk. Reading AQR research has helped me tremendously in understanding why specific market participants make decisions and how that connects with the correlations and positioning during macro regimes.

• Finally, reading these types of books and papers helps you begin to bridge the gap between what is purely pragmatic and the WHY behind things. For example, there are many principles traders use to manage risk or run trades. They don’t know WHY they work on a fundamental level but just that they work. For example, the way you stop yourself out of a trade or scale in and out can dramatically change your returns. If you know the WHY behind this, you can actually identify sources of alpha.

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AI Stocks:

Alright, let’s shift to something more interesting!

Last week I mentioned that I bought calls on an AI stock.

https://twitter.com/Globalflows/status/1662113613371576322

When you are approaching individual stocks, you really need to focus on the make up of the float. I mentioned that 26% of the float is short:

I'm sure all the shorts have great reasons to be short. However, the market is about liquidity and transactions.

Here is a great article on how to analyze an individual stock’s float: https://teslainvestor.blogspot.com/2020/04/the-mechanisms-that-fueled-tslas.html

What most people forget is that you need to connect your fundamental view with the specific makeup of an asset's buyers and sellers. You need to break down every major holder of a stock’s float and then identify if those participants will be constrained to buy or sell if specific events occur.

If my calls on ticker:AI expire worthless, then that is okay, but they could also 10x. I have sized the position so that they can go to 0.

Conclusion:

As you know I have launched a paid version of this Substack sharing even more analysis. Here is the original article breaking down WHY I started a paid version and what that looks like: Link

I just finished an analysis for paid Subscribers that can be found here:

Thanks for reading everyone!