“Research is what I’m doing when I don’t know what I’m doing.” – Wernher von Braun
In the hierarchy of preferred trade types, the riskless trade sits at the top. Capturing a perfectly hedged spread or pricing anamoly, or performing a round turn across the spread and back to flat in some temporal duration measured in micro- or even nanoseconds are examples of riskless trades. Like poker’s rare royal flush hand, a mechanism to persistently discover and then capture ~riskless trades is the most coveted of the trading world.
What comes next in this hierarchy is the directionless trade, where the trader essentially plays both sides of the trade and where success is achieved whether the target ultimately wins or loses. Like poker’s next-in-line straight flush hand, the key caveat to the directionless trade is the requirement that the price of the target moves; that there is enough volatility during the life of the trade to cover the cost of entering and maintaining that trade.
It is here that we need to pause and focus for today’s instructive tale involving our good friends at Virtu Financial and Flow Traders – as well as the implications this story might have for others that also travel in this neck of the woods:
In the early days of the derivatives markets, the application of option pricing theory was not universally distributed to say the least. A short list of players had mastered – and automated – the mathematics (and mechanics) of pricing and trading options far more than the bulk of those early market participants. As such, riskless conversion and reversal strategies could be employed almost at will to exploit pricing disparities – and harvest monstrously enviable profits.
In time, this kind of edge decayed – and these formerly riskless strategies started to grow risks, sometimes known as delta legs. In turn, these new delta exposures gave birth to fundamental research departments in what was formerly among the very first quant shops. (It was here that I serendipitously stubbed my toe and fell unwittingly into this bizarre business…)
Now, without venturing too deeply into the weeds from here, the way a derivatives trading firm industrializes its edge and scales its book, in particular, is by aligning an increasing roster of positions in such a way that the aggregate deltas form a straddle – like a huge “smile.” And, even though there will be offsetting (short theta) positions to neutralize the cost of the “portfolio straddle,” the net bias of the book should be long puts, calls and theta – which is the rate at which the value of an option decays.
It is here that we finally identify one of the key challenges of managing a large options book that is managed to protect against fat tail events: paying for the daily cost of theta. Back in the day, we used to “pay” for theta with short term trading ideas, usually around fundamental catalysts like FDA meetings for new drug trials and, of course, earnings announcement dates.
Due to the manual nature of devising these kinds of trade ideas, this component of the broader strategy was difficult to scale. If only there had been an automated trading mechanism that made money everyday that could cover the cost of theta in the options book. Hmmm, if only… (Do you see where I’m going with this?)
Here’s the problem (and, potentially, the opportunity) depending on where you sit at this poker table, and given the cards that you currently hold in your hand:
If you are paying close enough attention at home, recall the concept, metastrategy of nested alphas, from the recent piece on DRW. Yes, it’s a mouthful, but what it suggests is the idea of two or more complementary or self-reinforcing strategies that are designed, in part, to minimize costs, enhance performance, or both. (The “dark pool” craze among the leading broker-dealer banks and others is symbolic of this “nested metastrategy” concept.)
Among leading market makers, there is a subset that trade options as a core component of their trading strategies and another subset that does not (with the possible exception of portfolio hedging, as you will see shortly). Virtu and Flow Traders are among the latter group. In the case of Flow Traders, 28 quarters of 13F filings and precisely zero options positions were reported, so there are no charts to share on that score.
Virtu, on the other hand, has taken a very different path towards minimal use of options (and that is as a very recent portfolio hedge). The odd thing is that they have acquired companies that were steeped in options. When we look at our modeling of the Knight and GETCO lineages of 13F reporting, we see significant use of options – typically greater than 30% or 40% of 13F portfolio value – up until the point they get folded under the Virtu umbrella.
In the first chart below, Alphacution presents the Knight, GETCO and Virtu lineages of the portion of 13F portfolio values represented by options:
First, take note of the small detail that Virtu has submitted its 13F report for Q4 2018 as of Jan 16, 2019 – almost a month early from previous years when most prop-oriented firms would take full advantage of the 45-day post-quarter-ending window available to disclose these positions. Now, notice that with the exception of the dramatic and unprecedented spike in allocation of 13F portfolio value to options by the end of 2018 (35.5%), Virtu’s allocation to options over the previous 36 quarterly reports had never exceeded 11.4% (and had averaged 2.2%). Why the spike in usage now?
Lastly, what’s potentially more interesting here is that 35.5% of 13F portfolio value for Q4 2018 is made up of just 9 positions – 4 puts and 5 calls – 6 of which are among the 10 largest positions and each of these on broad market ETFs. In other words, this option penetration represents 0.5% of a total 1,673 positions for this latest quarter; a strategy that has persisted for all 3 lineages for the 12 quarters beginning Q1 2016, see below:
So, the unprecedented shift in portfolio hedge strategy just in the last several weeks notwithstanding, our concern is that the (very few) players that incorporate market making or high-performance trading in options and their underlyings are in a stronger position to be more aggressive and to cross more spreads than those who are singularly focused on positions in the cash markets. Not to mix our metaphors with the poker game we started at the outset, but this is somewhat like the difference between playing checkers and chess – or to be a bit more generous, chess and 3-dimensional chess.
One game is linear and the other has curves, and those that are fluent in the world of curves tend to be in a stronger position mathematically and mechanically.
Finally, if you think we’re picking on anybody – or, rooting against anyone’s success – you’d be seriously mistaken. These markets need more players and more diversity of strategy and positioning, not less. If one or two dominant players squeeze everyone else out of this critical segment of the markets – an area Alphacution has been calling the structural alpha zone – it is not good for the overall health of the markets…
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