#writing Morality is non-linear and one of our best tools for measuring and quantifying non-linear relationships is the Black Scholes model. We err when we make linear moral choices like the greater good outweighs any individual outcome. The framework underlying Black Scholes can help us understand how we err. We see the outcomes of these errors in society today with a case in point being the current election narratives. We can apply this model to the current movement to list illiquid private assets in liquid ETF vehicles. **LinkedIn Post** This week we are exploring how an options valuation model can inform moral decisions. Immoral decisions, like stealing, usually start out as a small justification but grow into something much larger. Telling the first lie requires a second lie to support the first and so on. This dynamic is similar to being short volatility where you are constantly fighting the market to keep your position in balance. We then take this framework and apply it to the current election narratives and the push to list private asset ETFs. By measuring the cost and risk of short-term benefits it helps us weigh them against long-term cost and risk. refs: @dailydirtnap - www.shortprivateequity.com @KrisAbdelmessih --- **October 21, 2024** Morality is not concrete. The difference between right and wrong is up for debate. Much of it depends on your point of view or you’re framing. I re-watched a Few Good Men recently and it provided a great example of how we can twist moral decisions to our will. Jack Nicholas' character, Colonel Nathan R. Jessup, justified the torture and killing of one of his soldiers because it was saving lives by providing better national defense. History is littered with rationalizations like this. The very fact that we still write and make movies about it shows it is an intractable problem. This election has been framed as a battle against the deep state that wishes to impose its morality on us or about moving forward instead of backward by making the US a country of opportunity instead of a country where there are lots of billionaires. It is a sad situation that we cannot enjoy the institutions our soldiers gave their lives for and it's a shame that we now vilify success. Being long or short volatility by trading options (options are choices) is akin to a moral choice. In Les Misérables, Jean Val Jean chose to steal bread to feed his family and become trapped by the consequences of that choice.  Being short volatility, you are continually forced to buy high and sell low to defend your position as you keep one eye on the clock anxiously counting the days to expiration. Kris Abdelmessih, proprietor of [Moontower](https://moontowermeta.com/), has called the math of short volatility "diabolical." Selling options is akin to a course of action that gives you fewer choices because you have taken a short-term good (the option premium) in exchange for fewer options in the future (delta hedging). In the parlance of poker, you don't have as many outs. Nassim Taleb calls this fragility; nutritionists advise against eating sugary foods because of the resulting crash after the sugar high wears off. We run into this dynamic all the time; it is ubiquitous. The Black-Scholes model is something options traders and finance bros know about but the average person on the street probably does not because conventional wisdom says they have no need to understand such a complex tool with narrow applications. However, as often is the case, the conventional wisdom is probably wrong. **Black-Scholes provides a quantitative framework for understanding the abstract nature of morality by quantifying the risk and reward of the choices we face.** This isn't meant to suggest that you can plug the calories of your favorite snack into the model and it will tell you how much time you have before the sugar high wears off, but it does give us _something_ concrete, in terms of numbers, that we can use to understand the magnitudes of the different vectors that the choices we make may lead to. By giving us a framework for applying universal principals like not valuing the short-term at the expense of the long-term, of putting yourself in a position to succeed, and not eating too many sugary foods in the afternoon, it helps us make more efficient decisions just like it is used by options traders to make more informed trading decisions. It is generally understood that short-term decisions tend to come at the expense of long-term results, but that understanding doesn't stop short-term thinking because it is easier to feel the tangible, short-term rewards than it is to measure the long-term risk. Similarly, just focusing on the long-term or trying to always put yourself in a position where you have many options may lead you to never take [[risk]], and we know that a life without risk is not worth living. Black-Scholes gives us a yard stick for the non-linear risk we face all the time in life. It provides an intuitive framework for translating the range of possible outcomes into measurable risk and reward which allows us to shift our focus from outcomes to positioning ourselves within the distribution of potential outcomes. This quickly reduces anxiety by freeing our egos from the outcomes of our choices which also puts us in a more robust state to make better decisions. For example, when the domain is high-risk, i.e. the range of outcomes is wide or the tail events come with a high cost, we should only accept risk when we are being compensated richly for it. Similarly, when the range of outcomes is well known, and the costs are low we should be more willing to accept risk. However, we often do just the opposite and this is where an appreciation of Black-Scholes can be leveraged outside of the options market. For a real-time example of this we don't have to look very far in the news today. Apollo recently filed an application to [list a private asset ETF](https://www.morningstar.com/funds/closer-look-groundbreaking-active-etf-proposal). The popularity of private assets has grown with their returns and short-term money inevitably finds its way into the highest returning assets. The public markets are dominated by short-term money because they are the most liquid markets and therefore provide the lowest cost of capital for companies. This is an important cause-effect relationship to remember: short-term = higher liquidity. The populist argument for listing private asset ETFs is it gives mom and pop investors access to high-returning investments that only wealthy and sophisticated investors have access to. The proponents hail the magic of our capital markets in providing liquidity and low-cost capital to enterprises that have changed the world. I [chimed in](https://x.com/cedarshill/status/1847681962489659539?s=46&t=YoaI5wQds4cxaj_3FKnUyg) on this to say that we need to revisit the idea that liquidity is a magical force that has no adverse side effects. Populist arguments tend to be like the afternoon sugary snack: they taste great and give you a short-term boost but come at the cost of crash later in the afternoon. [[Liquidity|Since volatility is the price of liquidity]] we know that private assets today enjoy lower volatility than public assets, which has been a key ingredient to their success and popularity. Greater liquidity from a public listing would lower the cost of capital but at the cost of higher volatility. The owners of private assets today will be the primary beneficiaries of their increased liquidity because it will raise the price of their investments which may also reveal a [hidden and insidious motivation for listing these assets](https://www.bain.com/insights/private-equity-outlook-liquidity-imperative-global-private-equity-report-2024/). The public market investors will benefit from a wider menu of investment options and sources of uncorrelated returns however they will come with a steep price and higher volatility. Not only are the PE firms able to monetize their investments at a higher price but they are also positioning themselves as the market makers providing the liquidity to the retail investors. Essentially, they get to double dip by taking gains and then selling liquidity at a high price. To get an idea of what this could look like imagine the headlines when retail investors panic out of their private asset ETFs by hitting the PE back bids further enriching the billionaire PE managers at the expense of the average investor. The SEC mandates certain liquidity thresholds for these ETFs which means that investors are short the liquidity option because they are accepting a lower return (the option premium) for an asset just because it is in a more liquid vehicle. While it may seem like they benefit from the liquidity, if the liquidity is not priced accurately the investors paying for that liquidity are probably paying too much. Just like the [[Jensen's Inequality|rats that keep pushing the lever]], investors think they can enjoy the past performance of private investments with greater liquidity without realizing the reward function of the investment has changed. If you take a step back, you may start to see how giving people what they want without regard to its value, utility, their need for it, or their capacity for understanding it is not all that different from Colonel Jessup justifying murder based on national security. While that may seem like a stretch, just look at the issues social media has caused and the adverse effects of legalized sports betting. By casually associating liquidity with a public good without understanding its cost we create fertile ground for resentment, division, mistrust of our institutions, and the disregard for success that we see today. Every banking crisis in history is an example of this. An appreciation of the intuition behind Black-Scholes provides a framework to understand these complex tradeoffs. It provides an equality that must always balance because the probability distribution of life must always sum to 100%. We can't have our cake and eat it too because of the supposed magic of our capital markets. The capital markets are amazing, but they come with a cost (just like social media and gambling) and a better understanding of that cost will help us understand the true causality behind the inequality we experience and prevent us from misdirecting our blame. Black-Scholes provides a numerical framework for one of the oldest lessons in history: >‘“Enter by the narrow gate; for wide is the gate and broad is the way that leads to destruction, and there are many who go in by it. Because narrow is the gate and difficult is the way which leads to life, and there are few who find it.' > [Matthew 7:13-14](https://www.bible.com/bible/114/MAT.7.13-14)