Postmodern Society and Its Future

Malt Liquidity 144

Liquidity: the friction between theory and reality

Liquidity theory: An ought becomes an is when there is a sufficient amount of speculation as to whether an outcome is or ought to happen.

“Does a tree that falls in the middle of an empty forest make a sound? Yes, precisely when enough people say they heard it.”

It’s done. The project of defining liquidity theory is done. Here’s how I got here.

An intro in many of the longform pieces I write talks about how speculation is innate to the human nature (This is Howey Do It — Rethinking the Security):

From a simple transaction where one might lend to someone based on a recommendation of a friend to meticulous record keeping of weather patterns to predict when the next rainy season will come, speculation comes as a derivative of human curiosity. It logically follows that a simple question we might ask our parents endlessly as a child — “why” — leads to a similar question — “what happens? — that can be answered much more deeply with much more than words. In preparation for a long winter season, a farmer might stockpile grain for their family. Or, if one had a more profit-oriented motive in mind, as the famous Homer Simpson quote goes, one might invest in pumpkins: “They’ve been going up the whole month of October. And I got a feeling they’re going to peak right around January and that’s when I’ll cash in.”

Everything I have done, in a sense, has been towards figuring out that question of “why we ask why” — which logically extends to “why do we trade”. In grade school, I was known for correcting my teachers incessantly, and when told to just do my work, this discontentment never left. The areas I mastered: chess, intensive pattern recognition so we know that we are speculating with confidence, math, rigorous formal logic that attempts to quantify and codify the infinite, and trading, testing my theories and being validated by profit, all reflect a different way of trying to solve that question.

I mentioned that this would be the last Malt Liquidity post, and honestly, I was overwhelmed by the amount of responses I got that thanked me for writing, and expressed sadness that I’m hanging it up. Don’t worry, I’m not going to stop writing — this project is complete, in a sense, but there are plenty of other interesting questions to explore. I’m glad so many people followed along the way, and this is the conclusion — if there is a method of directly shorting the volatility surrounding an event, then the outcome eventually enforces. The “ought to happen” becomes “must happen” as the timeline to expiry goes to zero.

I started out by working backwards. It’s well known that normal humans err by finding patterns in pseudorandomness, so the logical quantitative method is based upon deriving actual patterns through analyzing the data. But true randomness isn’t knowable — therefore there must be some pattern that exists, but you just have to find it to predict an outcome. Then, for it to be realized, everyone else must realize it at some point. Everything works like this.

From the very first Malt Liquidity, in 2020:

I’m an insomniac - as such, I find myself awake a lot of the time with not much to do between 3 a.m. and 5 a.m…

A common aphorism in saving for the average person is to “passively invest” - rather than trying to actively “beat” the market measure of your choice, the suggestion is to buy market-tracking ETFs, such as SPY, which tracks the S&P 500. However, if the S&P 500 is adding and subtracting companies to its index composition, isn’t that, technically speaking, an “actively managed fund”?

It’s useful to look at financial markets from a standpoint similar to Newton’s Third Law - for every movement in a financial product, there is a product tied to it that will adjust accordingly (though not “equal and opposite” - there are far too many products built on top of products with non-linear relations for anything in finance to be this simplistic.) As such, the addition of Tesla to the S&P 500 would impact every ETF tracking the index, the futures tied to the index, the options on all these theoretically - identically moving products, the volatility measures on the index that are traded, the options on those, and so forth, due to the fact that while everything is priced according to the index, the actual shares making up the ETF must be held somewhere in the weights corresponding to S&P’s weights. Generally speaking, ETF rebalancing is a humdrum occurrence at the end of every trading day - however, Tesla is a fairly illiquid and extremely volatile stock which also requires large amounts of collateral to trade, given its weighting and market capitalization. Thus the problem arises of everyone knowing that all these ETFs do, in fact, have to buy the shares in some form, and, naturally, taking the liquidity currently being provided to front-run all the big asset managers buying it. You see this happen occasionally when products roll over or terminate - the negative oil fiasco earlier in the year was explicitly compounded due to USO’s rollover schedule being public knowledge - but Tesla split just a few months ago which one would assume made the stock more liquid, but is actually not so clear…

“Soft Solved”, “Enforced Beta”, “Variably Rigged”, these are all the exact terms surrounding the concept that the infinite is unquantifiable and unknowable but we must put systems in place to account for it. This friction is undeniable. Thus there must be some element that controls this system to make it pseudorandom so normal people can follow the action. This is what I was seeing in 2018, during the infamous week XIV blew up.

This is why gambling is the core of every sport, both good and bad. To offer live odds, the outcome must be massaged to a knowable range because of the gap between real time and stopped flow. This is why gambling edge lives in live odds, and skilled bettors get bet capped — it’s a zero-day binomial option issuance process (football, for example, is a discrete time game) masquerading as a “live bet”. It’s not delta one!

Everything predictable can be framed as an option that becomes more and more predictable until it hits the moment of expiry. Anything else is unknowable. That’s the line. That’s why HFT is entirely the principle of “minimizing hold time minimizes risk”, and why polls are completely marketed nonsense up until they rapidly become high-signal around an election. Pretty similar to how theta decay works, innit? Alas, there’s no short vol mechanism in politics markets, so all you can do is frontrun noisy sentiment. There’s nothing else to it, and there’s nothing more depressing than spending all your time perusing literal fake content.

I think this is why I hate statistics so much. They can never describe what I’m seeing with my eyes. All they can do is tell me I’m wrong by using an approximated argument that doesn’t apply to my empirical one. But it’s unfalsifiable to claim this, so people won’t buy it. They live in the land of “proof”, “experts”, and “ratios”, rather than “it makes sense if it makes sense.”

Securitized reality is a simulation, but it’s just not knowable when the curtain reveals itself. We don’t know when the universe expires. We can only hope to expand it. It’s not provable, but it is observable, and it’s why precise predictions of doom are never accurate but bad feelings tend to be more accurate than not. Obviously, I am not exactly a bullish individual, but I know that there are serious cracks in the system, and have written about plenty of them.

The only thing I can do with this knowledge is never publicly speculate on things. All the world’s a stage, and my role is to not mess with the show.

What I realized is that the “trick” that kickstarts liquidity in a belief-based system (fiat) is the fact that you have to get people to believe in it. If I endlessly point out how everything is constructed around an assumption, and continuously harangue the point that “it’s not real”, it becomes a self-fulfilling reality if my ideas hit critical mass. It’s why, when I hit the breakpoints of where I’d start to reinforce in the attention-economy (because, much like trading volumes, organic content is so few and far between that legitimate lunatics — think Jeremy Fragrance — have “tapped in” to the algorithm and are growing larger and larger), I had to solve this idea and stop expounding on it immediately.

I’m never going to stop trading, because I have to continue to validate my intuition indefinitely. But there is nothing more I can do to explain the postmodern market state, the attention economy, and how all these cross-correlated markets fluctuate and disperse. The entire attention economy revolves around this theory. It’s why everything is getting more and more predictable to me as everything becomes securitized, because people don’t realize they are trading binomial options issued in near-real time and treating it as shares, and they are blowing up faster than ever.

As soon as an attention trend hits critical mass it becomes knowable for exactly how long it will spread, and that’s why our attention spans are shorter and shorter. Everyone is adapting to the instantaneous rate of transmission. Reality thus constructs itself around altering expiries of attention spans of demographics, which have a hard expiry on elections. It’s why politics is a rigged game where we don’t know the result until right before it happens. Of course it’s rigged! The entire point of a centralized government apparatus is to short societal volatility. Someone has to know the outcome in advance, even though it’s uncertain when exactly the election is “called” for one side or the other. It’s not a conspiracy, it is the literal job of the government to not upend society. Pulling up the curtain creates pure discord.

But, this is why everyone gets exhausted. Humans have a finite level of attention span reduction while computers can only keep trying to overfit and spread information at the highest frequency. Humanity is at the end of its tether emotionally for this very reason.

This is why I get the feeling that something seems more off the more all of my intuition gets confirmed. Frenetic information absorption means nothing will ever happen, sure clarity means an inflection point is coming.

I don’t want to verbalize what I’m thinking because I am not a prophet, but my intuition feels that something very, very off. It’s why I have so much inner clarity, internal zen. The insights are all in my writing: the amount of crowding around everything is dangerous, there’s too much competition for liquidity, and there’s not enough real flow to go around, and people are burnt out and tired of it, and it cannot be subsidized artificially anymore. We are going to get a post-FFR meta in my lifetime, is what I have concluded, and I simply don’t know what that looks like. It’s unpredictable.

You need there to be enough uncertainty in the market so that there is organic flow to market-make. Else it's just a passive game of Pong played in the background. It's why all the prices aren't real on the visible bid-ask and trading feels like bucket shop days. In a sense, it's exhilarating, but bucket shops could reject flow, and it wasn't possible to trade at the speed of latency.

This is why the only financial regulation needed to be hard leverage limits on cash and net notional. It makes people trade and not just scale size and collect fees and trap liquidity and organic flow away. It controls for people rogue trading. You need trading of deposits beyond solved problems like interest payments. Otherwise, things become illiquid, and SVB happens. People need to believe in fundamental valuation in the same way they need to believe the central bank controls inflation. Dollars need to reflect productivity. The growth numbers must go up. It all must connect because organic single stock flow is the true liquidity in the market, and everything else revolves around it. Otherwise, the price prints become less, and less, and less real.

How I derived all this was from a single hypothetical when I learned about create-redeem: what happens if there is no volume in the underlying? How does the basket maintain its NAV? If nobody provides organic flow, what results is a game of Pong. "percent passive" means nothing when everything is correlated exposure. Do people trust the real time prices? Clearly, the answer is no. People wait just like algos wait and things float. It's why you can trade less and less hours in a day to make money.

Inflation targeting is just conveying to the markets what the velocity of money should be. The FFR has to lag treasuries because the entire point is you don't fight the fed, and it tells the market where to go. Too much inflation or too little, wealth polarizes due to different reasons. The baseline risk does not match the rate the game needs to be played at. You need normal people to think they can beat the market picking stocks, not get picked off nonstop on bad orderflow. PFOF is a great model for stocks, but options commissions should never have gone to zero. This is entirely why the market structure shifted after Robinhood scaled. It’s probably the most important tech company of the ZIRP era, as a result.

When people lose too fast, they begin to lose their belief. When they can see everyone else getting rich on paper or on social media (and it's all fake), they attach to weird, insane content that's organic (Jeremy F.) That's why the Forex Lifestyle guys and Tate dropped off so hard. It's why GME happened. People are hopeless and feel broke and the fake jobs and GDP numbers and rate cuts aren't making them buy in anymore. Add on the fact that everything has been securitized, and you have distributed liquidity across too many products. It can't concentrate unless people trade it. It only trades if it trades.

Thus everyone waits. Sizable players have an information edge in how the business works, but the illusion that this connects to the stock price has been destroyed. So they go to attention cycling. The end result is that any trader can only go where the liquidity is, which is why TSLA was the precursor to GME was the precursor to NVDA. They all congregated in the same way because the only thing to do is what everyone else is, which gets them trading again. And the entire market must revolve around whatever is the “real” flow.

The passive regime cannot sustain while being enforced by interest rates, influencers (lol at how big ETF reporters are, it's insane that people cheerlead filings on the internet…), the law (man, Gensler really went nuts) and people can't be losing too fast (derivatives are implicit leverage) and they can't be betting on everything that ever exists. This is precisely why trading hours are reduced, rather than expanded, in Japan. Everything has worked to stretch the market so thin that there's barely any liquidity to be found.

When I finally derived the definition of liquidity theory at the top, I found a way to frame exactly what I was thinking, and it scared the shit out of me. Trying to explain the unprovable is precisely the reason why people get lost in fake models and prophets and signals that don't really explain why anything trades and get depressed. Trading is the postmodern religion. It can't be knowable, but it can make you money, because we bucket reality into time. That's why 24 hour trading breaks the illusion of the business success being reflected in the share price.

The way to beat the market is to believe you can. It helps you avoid false prophets that claim to understand how it works. They only have their own self-interests at heart, or they are trying to convey in good faith something that can't be generalized and processed by regular people. Trading fluidly is in the individual themselves. And you will be rewarded, because the market rewards organic liquidity. The only way you blow up trading is by over-levering. There's no indicator that can prevent that. You can only take what the book is giving you, and leave it at that.

The only way to be content trading is to not forcibly scale it, go around talking about how you've solved the market, tell stories, and raise money because then you're stuck in the same problem as everyone else — there's nowhere to place the money but where everyone else does. There isn’t enough liquidity at giga-scale to enter the market day in, day out. This is why passive investing inherently cannot be the dominant frame of thought. It's a liquidity suck. The only way to be content with profit is by not showing off how much you have or what you're doing or how smart you are. That's the only psychology you need. If you hit that realization, losing money will never faze you, no matter what statistics tell you, because you can always find an organic way to speculate again. That's "trading in the zone".

Thus, my favorite phrase returns: I proved why passive investing doesn't work — it assumes liquidity. I've been using that phrase for half a decade, and I figured out exactly how it applies to market structure. That's the root of how we go back — people need to stop believing in ETFs.

The realization I have come to is that I can’t permanently exist in the hyperreal, the space between the internet and the real. It’s too frictionless. It will drive my mind nuts if I keep seeing too much reinforcement of my thoughts. Obviously I will gladly offer insight, but I’m done predicting outcomes and going “I told you so.” I handwrote a blog post the other day and it was great. I had to stop like I can’t stop typing. My hands have to do more than type out thought flow, and it introduces an organic stopping point.

I’m not going to try and convince someone because I don’t have to anymore, it’s proven. I’ll still be managing my assets and will offer some insights in this newsletter, but it’s just an organic point for your own thought to leap off of. And: go slowly. Try and capture the spread between your thoughts and mine, and work through the context of all the concepts I’ve come up with, and figure out a way to prove it wrong.

The first stock I ever bought was JBLU. I would check the price every single day, and I wondered why the share price would move in real time when everyone would trade around the news. So I started to trade as a test of my theories on reality. The reason I sound like this is because I've solved every question I could ever have about the internet age's market structure, until it changes. What more needs to be said?

Instead of pointing out how everything is flawed and doomed, I’m going to say what needs to happen going forward.

To organically de-lever the financial system, we must go back to stock picking, not options trading. Single stock flow must be the base of market liquidity. Enforced beta —> enforced Vega. There must be a “reason” the stocks move. News has to become real again. For this, I have to enter the real world, where money is a means to an end, and nothing more. That man who buys the six pack at the end of the week, watches the news, and shouts at the TV, must be happy in his ignorance and in how he picks stocks.

The people losing the most are precisely the people who can’t be told they’re the dumbest and the poorest. They grow hopeless, they give up. Another way to say “don’t give up”, is, keep speculating. We can’t make fun of the dumb flow because they allow smart people to play the derivative games. Chess to their MMA. There’s value in both. For this, organically, leverage has to be disincentivized — it’s the derivative of debt, which is why interest makes leverage so unstable. We cannot be so condescending to the point where so much edge is sucked out of their bets that they get desperate, and borrow. People don’t realize the implicit leverage in every bit of margin lending they experience. A paycheck is a margin loan for the next two weeks of labor. A car loan, bills to pay, interest payments, all of this is implicit leverage. What kind of profitable clip does someone need to trade options at to break even? I’m not sure it’s even possible for anyone other than a superhuman to make a return.

It is not humanly possible for pretty much anyone other than a very select few people with a similar knowledge base of mine to parse this scrawl and work their way to what I have. I write math in words, and in a lot of them, and endlessly self-reference and loop back and forth to make my points. It’s like Money Stuff + Infinite Jest + Gravity’s Rainbow, except the rainbow is a gamma curve.

Why I need to end the Malt Liquidity thread (and I’m going to make an independent stand-alone webpage soon that helps parse the core posts in a much more digestible format) is because I have to make it easier, and more relatable, to nudge people implicitly to deliver their trading style. I need the Homers of the world to bet on pumpkins and not have the illusion revealed as to what term structure and contango are — most of the population cannot calculate a tip in their head, how am I supposed to explain that I can see partial derivatives through my eyes?

Leverage is the ultimate drug in finance, and ZIRP unbounded reality from the Martingale condition. It’s too rewarding to high skill and low skill players. It’s why I have always said the only regulation that is needed is leverage limits, which could be thought of as a form temperance. I need to convince the Adams and Eves to not bite the ask on the AAPL call option.

While I’m building the new site, here’s the ultimate way to read Malt Liquidity:

Start with the last post (this one). Each time a prior writing of mine is linked, click and read that post, then go back to reading the original post. When you get to the end, go backwards one post (aka 144→143). If you get confused about a topic, click the hyperlinks until you understand what I’m talking about.

The reason it has to be read this way is because my writing got significantly clearer at the end, and if you are trying to learn to reason from first principles, unless you are literally me, it won’t make sense to start from the point I did and reason things out.

I think I have touched basically every topic on the planet that could be relevant to a regular trader’s life, and plenty of institutional ones as well. I’m leaving this as a testament to the work I’ve done over the years. I didn’t make any money off it, but that also means I don’t owe anything to anyone. In a way, that’s the least levered thing you can do.

I’m probably going to put a paywall on posts, just so they aren’t scraped. I promise everything going forward will remain entertaining, still tie into markets here and there, and be much simpler to comprehend (and should be free.) If Malt Liquidity is considered creative nonfiction, what’s going to come next will be more of a fictionalized reality. I’m still going to talk about the markets, but I’m going to try and tell a story that’s much easier to comprehend. If you dig through those details, and put it together with liquidity theory, I’m sure we’ll all be prepared for the market regime that comes next.

Thanks for reading, everyone, I truly appreciate every single interaction that helped me get to where I am.

I’d like to buy the world KO today…

For those of you who want the archive, rather than the full adventure, I’ll leave it at the bottom of this post, so I can pin this one.