Deepseek And The Power of Catalysts
A 50-Bagger in a Weekend
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Deepseek And The Power of Catalysts
Note: I typically write about long investment horizons but that isn’t the case today. So this article might just be blasphemous since investing is “supposed to be long term”… but then again, as I’ve said before, there are no rules in investing.
Ok, so last October, I shared A Simple (But Not Easy) Investment Strategy. It involved 2 steps:
Step 1: Identify catalysts that can create sharp price movements
Step 2: Use options to construct highly asymmetric bets
If you’re new to options, you can quickly learn the basics here:
Well, the DeepSeek news a few weeks ago was certainly such a catalyst.
DeepSeek unsettled global markets with the launch of its open source reasoning LLM, which was supposedly built and trained for a fraction of the cost of models from much larger US competitors. As a result, fears began to rise that perhaps tech companies were spending too aggressively on artificial intelligence. This in turn questioned whether Nvidia's growth rate would decline significantly if big tech were to scale back on next-gen investments.
As a result, when the markets opened after the weekend, on Monday January 27, NVDA 0.00%↑ experienced a whopping 16% drop in a single day.
I was curious how much Nvidia put options performed due to the drop.
Here’s What I Found:
First, which puts? I selected puts expiring in 1 week, 2 weeks, and 4 weeks. Why these dates? Because catalysts such as these tend to have immediate price impact.
Second, I selected strike prices 5%, 7%, and 10% below Friday’s closing price of $142.62. Why these? I figure a catalyst that isn’t able to move prices by at least 5% is probably not worth identifying.
Here are the prices of these option contracts on Friday 1/24 vs Monday 1/27. As you can see, there were massive price movements!
FYI - you can unpack the contract name format as follows:
.{Ticker}{expiration date: YYMMDD}{P=PUT}{strike price}
Here is what the return would have been had you purchased the options at Friday’s low of the day.
Here is what the return would have been had you purchased the options at Friday’s high of the day.
Here is what your return would have been had you purchased the options at the midpoint of Friday’s price range.
What can we learn from these results?
First, don’t get me wrong, a bet like this is extremely low-probability. The expected value however may just be quite positive.
Options expiring in a week experienced the biggest moves: 50+ baggers if one sold at the open. A couple of the above permutations even returned 100x in just one weekend! Now that’s the power of catalysts.
The returns from the puts expiring 2 weeks and 4 weeks out in the future aren’t too shabby either.
This Jeff Bezos quote comes to mind.
“We all know that if you swing for the fences, you’re going to strike out a lot, but you’re also going to hit some home runs. The difference between baseball and business, however, is that baseball has a truncated outcome distribution. When you swing, no matter how well you connect with the ball, the most runs you can get is four.
In business, every once in a while, when you step up to the plate, you can score 1,000 runs.”
-Jeff Bezos, Founder, Amazon
The above results are very much like stepping up to the plate and scoring a 1000 runs.
The hard part is identifying the catalyst and building the conviction to bet on it.
Can Such Catalysts Actually Be Predicted?
Betting on the above likely wasn’t predictable.
But that doesn’t mean catalysts can’t be identified. I believe we simply have to train our minds to spot them. I shared a few examples earlier: [Link].
The most obvious catalyst of 2024 was the US Election. And it was definitely predictable.
How could we have bet on that?
Well, we would have needed to think about the daisy chain reaction of events that might happen because of the election.
For example:
If Trump wins ⇒ markets could exhibit animal spirits
If markets exhibit animal spirits ⇒ certain sectors or companies would appreciate in price in short order.
In this example:
First we had to predict whether Trump would win: In the days leading up to the US election, pollsters had the race deadlocked. The vote was essentially a coin flip. Prediction markets on the other hand predicted that the odds were much more in President Trump’s favor (58% vs 42%). So we could assume Prob(Trump Victory) = ~58%
Second, we had to come up with Prob(animal spirits given a trump victory). I’d put this at 50%, a coin flip. Some might argue that I am being conservative here. Others may think that’s quite aggressive. It’s subjective.
Third, we had to identify that if indeed the markets exhibited animal spirits, what would benefit and appreciate?
Bitcoin was an obvious benefactor. (Trump is the Bitcoin president)
TSLA was another due to (a) Elon’s close proximity to Trump during the election and (b) The EV industry likely benefitting from regulations that can speed up the adoption of autonomous vehicles).
The Financials sector was another good choice. (Trump = pro business administration = lower financial regulations = good for financials).
There were many others as well.
In my opinion, we could assign each of the above 80-90% probabilities, given animal spirits, that their prices would appreciate.
This means the overall probability could be estimated as follows:
Prob (trump wins) * Prob (animal spirits given trump wins) * Prob ( benefactor appreciates in price given animal spirits) = 58% * 50% * 85% = ~25%.
Now, if there was a 25% chance Bitcoin or TSLA prices would spike (and it would not be a stretch to assume at least a +5% move), that’s interesting!
So how did the underlying option prices actually perform?
Let’s use Tesla options as an example to get a sense of the magnitude of price moves.
Lets see what happened to call options that expired in 1, 2, 4 and 8 weeks. Also, with similar reasoning as above, let’s use strike prices 5%, 10% and 20% above the Nov 5 2024 closing price of $251.44.
Tesla (Daily) Option Price Performance
Here is how the options performed. Unbelievable!
Do you still believe the market is efficient?
Below are the actual price charts for each of the option contracts selected above.
Price Charts of Options Expiring In 1 Week (on Nov 8 2024)
Price Charts of Options Expiring In 2 Weeks (on Nov 15 2024)
Price Charts of Options Expiring In 4 Weeks (on Nov 29 2024)
Price Charts of Options Expiring In 8 Weeks (on Dec 20 2024)
What’s Our Takeaway?
As you can see, catalysts can create significant price movements and hence significant outcomes, and can do so very quickly.
It is indeed practical to identify such catalysts. Not easy, but definitely doable.
Of course we cannot expect to capture the maximum potential gains listed above, but despite that, betting on these can be quite lucrative:
If one were to identify and place small bets on say 5-10 catalysts in a calendar year, even if one of them worked out, that could immensely improve portfolio performance.
On the downside, if none of them work out, the portfolio downside is minimal: Heads You Win Big, Tails You Don’t Lose Much.
Selecting the option contracts carry multiple tradeoffs. For example,
Options expiring in the very near term or ones significantly out of the money can generate massive outcomes, but are likely very hard to hold onto for any meaningful time period. Imagine you had a 5X unrealized gain with just a few days remaining until expiration. Would you want to keep holding on? Yes those options could turn into a 10-20 bagger, but it would be very tough not to sell those options. As we know, in the short term, price volatility can be unpredictable. I suppose this is a good problem to have.
On the other hand, if we pick options in the money or if we choose an expiry date too many weeks or months out in the future, our expected value return might not be large enough to warrant such a bet.
So it’s a delicate tradeoff, which is what makes this challenging.
We’ve simply used basic long call or put options in the examples above. There are more sophisticated alternative ways to place our bets. But, a simple approach definitely appeals to me.
If You’re Still Reading…
Do you think you are good at identifying such catalysts?
Send me a message: maybe we can put together a small WhatsApp group to share catalysts?
Take care and happy investing!
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