“If we knew what it was we were doing, it wouldn’t be called research, would it?” – Albert Einstein
For this one we need to go all the way back to the first time we illustrated the fact that KCG’s market making operation – the artist fka GETCO (or, Octeg for the uber-insiders) – was more sensitive to volatility than Virtu’s market making operation, as illustrated below:
Now, I know we’ve spent an inordinate amount of time on these names and related topics, but I’m going to beg your indulgence on this one because the findings are uniquely cool – and I’ll keep it fairly short:
Specific sensitivities to volatility by different trading platforms notwithstanding, the condition that yields the greatest potential for outperformance of these market making strategies tends to occur when realized volatility exceeds implied volatility. It turns out that since these strategies are actually not set up to predict volatility very well they are therefore designed to remain in a defensive posture along with the prevailing vol levels and then shift reactively to changes in volatility. Therefore, the secret sauce tends to come into play with the trigger that causes a move from defensive to offensive posture with regard to vol. Based on the chart above, the data shows that the GETCO strategy had, shall we say, an itchier trigger finger when it came to shifts in volatility.
Ok, now with that in mind, the exhibit below illustrates those few (quarterly) periods when realized volatility exceeded implied volatility for the 21-quarter period beginning Q1 2014 and ending Q1 2019. It’s only 3 times:
Here you will notice clearly how the first of these – the Q3 2015 period (when realized vol > implied vol) – corresponds to the greatest surge in net trading income for KCG given the range of the first chart. Now, recall that KCG is acquired and absorbed by Virtu during Q3 2017 and the various GETCO and Knight Capital assets are integrated into the ongoing Virtu platform.
With this migration in mind, notice what happens next: Yes, Q1 2018 is the second in our sample where realized vol exceeds implied vol thereby representing a “tide that lifts all boats” quite dramatically. We will return to this momentarily. But, then look at Q4 2018, the third in our sample of realized > implied vol periods. Here, there is a much more significant reaction in Virtu’s net trading income to the shift in volatility conditions in relation to the Flow Traders comparison:
I believe this is the original GETCO strategy still operating within the Virtu platform. Kudos to them for successfully preserving this unique brand of special sauce.
Now, let’s return to the spike in net trading income that corresponds with the dramatic spike in volatility during Q1 2018. Based on additional data reported by Flow Traders relating to ETP values traded by region and by quarter, we are able to calculate the average revenue capture (as measured in basis points – or, bps) for each region over the entire 21-quarter period.
In the exhibit below, Alphacution presents these findings. Note here that the prevailing revenue capture per dollar traded in the US averaged 1.3 bps for the 2 years beginning Q1 2017 (if we were to remove the impact of Q1 2018 from the dataset). With the Q1 2018 shift in volatility, average revenue capture in the US expanded by a factor of nearly 13x to 16.6 bps thus producing the unprecedented surge in net trading income and vaulting 2018 trading revenue for both firms to all time highs. Note also the muted reaction in European revenue capture during the Q1 2018 US vol shifts.
In closing, I want to point out the labeling of persistent alpha and accidental alpha (in the chart above) because it is important to the nature of how various market participants feed on the assembly of available opportunities. Yes, maybe a more charitable term would be “temporary alpha,” but then again even persistent alpha is usually temporary along some timeframe. Anyway, the point is that since the accuracy of volatility prediction is still generally formative, a trading firm cannot scale its operations predictably if it is banking on consistently “winning the lottery” like what happened in Q1 2018. In other words, they cannot rely on growth via accidental alpha. Trading firms can only grow and scale operations reliably via persistent alpha…
Of course, this begs the question for most traders and assets managers: Is your alpha persistent – and, if so, how temporary? – or simply accidental? You need to know. Alphacution is on a journey to quantify and more accurately answer these and many other questions that have historically eluded market participants.
Watch this space – inquire about subscription options for deeper learning…
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