Time Part 1

The ultimate equalizer and its role in investing

Entropy and time define our world. The narrative of our civilizations is disorder followed by short-lived order measured against the arrow of time. Nevertheless, even chaos is a function of time.

Financial markets, too, could be described by entropy and time. Capital driven by rational irrationality constantly chases better risk-reward, resulting in never-ending transactions. In other words, investing is an infinite game, unlike poker or other games of chance, which are finite because they have a defined time frame.

Every position, regardless of the tool we pick, is time-dependent. Simply put, investing is an infinite game consisting of an endless number of finite games. Nonetheless, by investing in equities, we easily ignore the importance of time. Stocks are implicitly time-dependent, unlike derivatives and bonds, which are explicitly time-dependent.

The more experience I gain in markets, the more I appreciate the gravity of time and the strengths of explicitly time-dependent assets like options and bonds. Being aware of time shifts my perspective upside down.

When buying a fixed-income security, time works for me. The closer the maturity, the more evident it is that I picked a good bond or at least did not pick a sloppy one. Conversely, when buying a call option, the time works against me. The closer the expiration, the more evident my wrong pick is. In both cases, I am aware of the impact of time. Hence, I can pick options and bonds suitable for my strategy within a particular time frame.

When investing in stocks, we almost always neglect time. It is easy to do so because stocks do not have maturity or expiration. What we overlook is the importance of time opportunity cost. Being invested in the dead money trade means we missed other profitable trades. In other words, equities are time-dependent, too.

Bonds, options, and equities are tools for expressing our views on the market, so they're part of our investing process. Remember, that process is defined by three stages: research, valuation, and execution. Most of the time, we fail miserably on the last stage, execution—trade timing and position sizing. A week ago, I published my take on diversification, where I briefly mentioned the Kelly formula as a position-sizing tool.

Today, it's time to reason about time as a prime variable in options investing.

As a side note, fixed-income securities deserve a separate article. In the coming weeks, I will publish an article on bonds.  

Option value, narrative, and fundamentals

To recap Part 1, by buying call options, we neutralize path dependency by becoming time-dependent. We also become volatility dependent. Another write up is coming on volatility.

The price of an option is inversely related to its life span. This variable, Theta θ,  is part of the Greeks that describe option premium. I treat Theta as a risk management fee.

No matter the volatility and price direction, time takes its toll. The reason is simple: the closer the expiration date is, the lower the chance the option will end up ITM (in the money). Conversely, the more time before the option expires, the greater the chance of reaching ITM.

A decrease in option premium as a function of time is called time decay. It describes the process of losing premium value as the option approaches expiration (chart via author’s archive).

You notice on the chart that for the last 30 days, option value has decreased rapidly—time decay is the maximum then.

I use one of the most straightforward option strategies: DOTM LEAPS. These are deep out-of-the-money options with at least 12 months until expiration. One of the reasons I like LEAPS so much is the dependency between narrative, fundamentals, and time.

Look at the chart below (chart via author’s archive):

When we follow the long-term trend, we give weight to fundamentals, which are relatively easier to predict than narrative shifts.

The market tends to be inefficiently-efficient within six months to a year. The price quickly absorbs narrative changes. Hence, all expectations are calculated. This is due to the speed of information distribution and democratized access to markets (and information).

This brings us as close as possible to the theoretical proposition that all market participants have equal access to the same information. Price discovery happens almost instantaneously, following the majority's expectations.

In shorter time frames, the fundamentals are ignored, so they are not priced in. The following graph illustrates this relationship in the short, medium, and long term (beyond one year). Chart via author’s archive.

In the short term, the market is more efficient than inefficient because it is driven mainly by narrative. As mentioned, market participants' consensus shifts are promptly reflected in the market price. Meanwhile, fundamentals are miscalculated, at least to say, and not priced in. Therefore, investors keep extrapolating the recent past into the imminent future.

Beyond 12 months, however, the fundamentals outweigh the narrative, and the price goes out of equilibrium. Hence, the proverbial Alpha reveals itself. In other words, unpopular scenarios driven by fundamentals gain traction and eventually become a new narrative while the old ones are abandoned.

The following quote sums it up:

In the short term, the narrative trumps the fundamentals. However, the fundamentals trump the narrative in the long term.

Our neurobiological wiring explains the short-term dependence on narrative and long-term dependence on fundamentals. Humans tend to focus on the recent past and the near future. It is not habitual for us to think long-term. We are organically circuited to think in short periods because our survival depended on it in the distant past. Life in the wilderness was day-to-day and hand-to-mouth. At best, to push through the winter.

Despite the immense technological advancements, this mentality remains deeply ingrained in our behavior. Combined with new technologies, it makes us highly reactive to markets, reflected in sharp shifts in consensus among participants. As I said, the narrative can overwhelm the fundamentals in the short term.

Nevertheless, eventually, the fundamentals prevail. To cash on fundamentals, we need proper tools. These are options with at least 12 months until expiration.

During that period, the narrative pendulum may swing multiple times while the fundamentals become the new narrative. Market participants will first timidly, then boldly, join the emerging trend. In doing so, they will add fuel to the fire—the trend will accelerate to reinforce the new narrative.

Final Thoughts

Time is the most misunderstood and underestimated aspect of human existence. The same could be said about investing as a function of time. Today’s essay aims to discuss time in the context of options.

I intentionally simplified explanations because my goal is to spark curiosity rather than give ready-made answers. The latter never works, especially in investing. As the saying goes, investing is simple, yet not easy. This is also 1000% for basic option strategies.

Furthermore, the options universe is enormous and complex. So, delivering easy-peasy, sweetened “content” means disrespecting myself, my readers, and investing as the greatest game ever.

Time and entropy are the ultimate winners. Nevertheless, we still have a chance to bet against the gods when playing the investing game. When investing, we wager on future events. And it’s all about time.

Being aware of how our investment performs depending on time is crucial. As said, time is a friend for bond investors (and option underwriters), while it is a foe for equity owners and option buyers. There is no shelter to hide from time dependency. Even if we are 100% cash exposed, we again pay a hefty toll: opportunity cost combined with an ever-creeping inflation.

That being said, never forget the role of time in investing.