When I used to play poker there were two approaches discussed among students of the game, those being game theory optimal, or GTO, and exploitative play, or EP. Some players tried to develop a GTO style and others went for the EP style.
A GTO player tries to play in a way that in a worst-case scenario would result in a Nash equilibrium result. That’s when no player can get an advantage on others. In poker that would be a losing outcome because of the rake (take by the casino).
In all other situations, where opponents deviate from GTO, they are slowly bleeding expected value. That doesn’t necessarily mean they are losing, but their expected value always should be negative straying from GTO. Of course, in practice, most poker variants are far too complex to correctly ascertain what the right GTO move would be. Proponents of this style are likely to come much closer.
An EP player is carefully observing the opponent and adjusting his play to exploit flaws in his or her opponent's game. The downside of that is the opponent may be expecting your adjustments. He or she is experiencing those adjustments a lot and may adjust to your adjustments before you’ve realized it. You almost always open yourself up to getting exploited yourself. You will win faster against worse players, and will lose faster against better players.
I’ve experimented with both approaches and liked the EP approach a lot better. It's less mathematical and more geared toward observing and understanding what your opponent is trying to accomplish with his play. At the same time, there are many valuable lessons in the GTO approach.
There's an apparent influx of new traders into the markets which I've discussed in previous notes. I’ve been thinking about this GTO vs. EP debate again. Translated to the investing world you could say that a broad-based market index is like a GTO approach.
It's very hard for your opponent to take advantage of you. The increased popularity of indexing is likely part of the explanation of the disappearance of alpha for active professional investors. Suddenly, you’re left to try and squeeze out your fellow professionals. I know from my poker endeavors that it's a lot harder. Indexing has gotten a bit out of hand, maybe getting derailed a bit from the GTO, but that’s a subject for a later date.
Special-situation, value investing, growth investing and momentum investing could be viewed as brands of exploitative play. Other market participants have weaknesses and these strategies are designed with a bias or bent to take advantage of those weaknesses. Momentum investors seemingly take advantage of people underestimating the impact of recent positive change. Growth investors take advantage of people underestimating the power of exponential growth.
As long as opponents continue to display their flaws, you’ll have a higher win rate translating in higher risk-adjusted returns. Lately, the value style is not working. Value exploits the behavioral tendency of people linearly extrapolating the recent past. Have other market participants stopped doing that? Or is the value investor having a bad run?
With these new and thus inexperienced investors into the investment world it looks like they are bringing their own strengths and weaknesses into the market.
I’ve been trying to take advantage of some of the price dislocations. But at times I’ve had too much exposure in my portfolio to the high-beta low-quality stocks (I'll go into more specifics in a bit) which is part of what these new investors seem to gravitate toward. Foolishly I did not offset this on the long side. That turned out to be very uncomfortable. The short side stormed upward while my longs didn't do nearly as well...
If past experience is any guide, these new entrants will soon be gone. Some with winnings others with losses. Some because the markets become more stable and boring. Others because sports betting is back. And others because of a bad run. A few will have found their calling.
Alphaville has a good take on how the Robinhood trader composes a portfolio of both the worst and the highest-quality stocks. I’m most interested in how they seem to be crowding into low-quality momentum names (airlines/cruise lines etc.) and I think because of some kind of Reddit / Robinhood / Modern social-media dynamic, this is resulting in some positive feedback loops.
They also seem to do a lot of call buying. Getting in early into these dynamics with calls is very attractive. Getting in late through calls is disastrous. Getting in late with calls can be so bad because the stock can actually move up and you’ll still end up losing money because the implied volatility is going down from where you were buying.
Looking at this through the lens of exploitative play I’m trying to think of strategies specifically to take advantage of this recent phenomenon.
I’ve come to the conclusion I can’t do it in size because even if I diversify across a number of these trades a lot of them are rather correlated. I’ve been shorting live events, casinos, cruise lines, and movie theaters because the characteristics of COVID-19 are such that I have a hard time seeing equity of such operators come through 2020/2021 unimpaired. Of course, they move in formation. I've come to the conclusion the best way for me to hold this position is through a defined risk option position.
Part I: Short low-quality names through options
You should know that I’ve never before explicitly written up an options strategy before.
If option chains are only available about a year or less into the future it could be interesting to have a call spread resulting in a net credit or alternatively put spreads. Investopedia has a clear explanation of a bear call spread here and a bear put spread here.
Graphically these positions look like this (per Fidelity):
For example, the U.S. Global Jets ETF (JETS) trades at $18. I can sell a December 2020 18 call for $3.90 and buy a December 2020 20 call for $3.10.
The maximum loss when the position resolves is $0.80 x 100 + transaction costs if JETS goes up to $20. If it moves below $18 I’m making $0.80 x 100 - transaction costs.
There's tremendous uncertainty around the future of airlines. The ETF for example is still nearly 50% down from pre COVID-19 levels. Air travel is actually not the kind of activity I’m expecting to do the worst for the longest. But they are bad businesses, to begin with, and they tend to have a lot of debt.
A position as outlined above gives me the opportunity to take advantage of heightened volatility. I also can bet outcomes are more likely skewed to the downside. At the same time, my risk is fixed.
If I can put together a basket of bets like that (with expiration dates of the positions spread out over the next 1-3 years) I’d think that will let me capture some of the fast-and-loose money coming into the market.
I would apply this to companies that fit three criteria:
- It's ridiculously overvalued from a fundamental perspective
- Recently has been ripping up
- Elevated implied volatility
The criteria are definitely not independent but they are good enough for an initial search through the top of the Robintrack app. A non-exclusive list of names that qualify are American Airlines (AAL), Carnival (CCL), Hertz (HTZ), AMC Entertainment (AMC), Virgin Galactic Holdings (SPCE), Nio (NIO), Tesla (TSLA) and Tilray (TLRY). I've applied this tactic to several of these names. Keep in mind that in some respect these are all the same trade. If you expect to be diversified by picking different companies you could be disappointed.