Article Summary:
- Understanding the players in the trading world is important to understand what role you should play in it.
- Businesses are profitable because they provide valuable services. To survive in the trading world, you must do the same.
- The markets you compete in can determine your success or failure. Trade in markets with less competition.
Introduction
Listening to many interviews with options fund managers gave me insight into how these traders approach the market and make decisions. As with any other business venture, options traders must understand their industry, why their business can be profitable, and where to set up shop. This has completely changed the way I look at the business of options trading.
Understanding the Industry
A wide variety of different market participants populates the trading industry. Both investors and businesses should take the time to understand the players in their industries to maximize their odds of success.
Market Makers
Market Makers are key players in the market as they quote prices and determine the bid-ask spread when assets are bought and sold. Market makers provide liquidity and enable traders to make trades instantaneously but at slightly worse prices than the midpoint. This makes market makers the primary suppliers for most retail traders. Retail traders should be mindful of this and aim to minimize their costs by effectively using limit orders – repeatedly hitting the bid or asking too often can cost you a lot over time.
Institutional Investors
Institutional Investors such as pension funds, mutual funds, and other money managers also play an essential role in the market by providing investment capital. They may opt to sell covered calls or buy puts as insurance policies against potential losses or leverage positions through options if they wish to gain from directional bets on certain assets.
QVR CIO Benn Eifert discusses the opportunities provided to them by price-insensitive options traders:
“The investment process that we run and the thought process behind it has always really about understanding how dislocations arise in the market, typically driven by … an end user of derivatives, who … is just a pension fund trying to do some risk hedging or a retail investor trying to buy a structured note.”””
It’s safe to assume that brilliant people direct most institutional funds. However, they might be playing a different game than we are. While they’re busy earning profits from the appreciation in equity markets, they may be okay with mispriced options from a volatility standpoint.
Market Makers often face the challenge of balancing institutional order flow to meet customer demand for a particular product. To accomplish this, they must adjust their prices away from fair value. Otherwise, they would be flooded with inventory since there is more investor demand for certain products than supply.
This adjustment from market makers allows traders like us to capitalize on this discrepancy by taking advantage of prices that may be slightly higher or lower than usual. By doing so, they can benefit from the difference between the market maker’s adjusted price and what would be considered fair value. While the pension fund is investing or hedging using options and the market maker is earning the bid-ask spread, we can profit by buying or selling mispriced options. By supplying highly demanded options or buying oversold options, we are carrying inventory risk that market makers cannot and are being able to buy cheap and sell expensive as compensation.
Hedge Funds and Prop Traders
Hedge Funds and Prop Traders serve to satisfy excess investor demand by selling overpriced assets while hedging their risk by buying similar (but not exactly equivalent) assets, thus generating profit when prices return to normal levels. As these prop shops snap up the most profitable opportunities, it can make finding attractive trades more difficult – these become our competitors in this space. It’s worth noting that there is a significant overlap between traditional market makers and prop traders since many prop shops employ market-making strategies when trading on financial markets.
However, large funds have large accounts, often passing over smaller opportunities perfect for the average retail trader. In addition, smaller stocks are less efficient as these stocks have less liquidity. Many firms also use partially or near fully automated trading strategies, so they may miss unique trading opportunities that arise occasionally.
Do Something Useful
In today’s competitive market, it is increasingly difficult to find mispriced assets for no reason. Trying to gain an edge through publicly available data is nearly impossible since all other investors also have that information. Common investment approaches — such as tracking CPI numbers and economic data — are not likely to generate superior returns, as all investors in the market have access to the same information. Nobody would willingly trade with you if they knew prices would improve in the future. Similarly, technical analysis such as Relative Strength Index (RSI) or Moving Average Convergence Divergence (MACD) indicators are widely used but are known to everyone. If these indicators worked, nobody would sell you stock during a bullish signal, and nobody would buy from you if everyone knew the signals were bearish.
However, there is still an opportunity to make money. Many successful institutional traders are out there – because they all provide some service to the market.
The biggest service traders can provide to the market is holding risk premia.
Risk Premia
In a TradingRoom podcast, Euan Sinclair spoke of how traders should build their businesses:
“Risk Premia should be, I think, the backbone of any trading strategy. There are other things you can do around that there are special situations you can look for … these are all things you should be trading. Still, they don’t happen often enough to form an entire professional [trading] operation … It’s kind of like a food pyramid.”
Risk premia is a concept that refers to the extra return or premium that investors receive for taking on certain risks in their investments. It is a concept that has been around since the mid-1800s and is an essential factor in portfolio management and asset allocation strategies.
In simplest terms, risk premia measures how much additional return an investor gets for taking on additional risks associated with a particular investment. This “premium” often comes from expected returns due to the uncertainties and volatility involved in investing, such as higher yields from stocks, bonds, commodities, real estate, currencies, and other assets.
As previously mentioned, some of the largest players in the market are institutional investors. Investors expect to earn a return on their capital in exchange for investing in a company that may fail to profit or go out of business entirely. This return is baked into the stock price; stocks are generally cheaper than the expected future cash flows generated by the company. Both parties benefit from the equity investment; pension funds earn a return on their capital, while companies receive the money they need to grow their business.
Similarly, investors who invest in high-yield debt securities typically earn higher returns than those who invest in low-yielding debt securities due to the additional risk associated with higher-yield securities.
It is worth keeping in mind, however, that investors are not compensated for all the risks they take in the market. They are only compensated for the risky things they do that provide value to others. For example, supplying equity and debt capital is useful to companies, but risky day trading may not provide that same value.
For options traders, we have a trading opportunity known as the volatility risk premium:
“The variance risk premium (VRP) concept describes how implied volatility tends to be greater than the subsequent realized volatility. This phenomenon presents an excellent opportunity for those willing to accept the risk of selling volatility by writing options contracts and collecting premiums.”
Previous studies have shown that the variance risk premium has a decent return, with Sharpe ratios between 0.5 to 1.5 depending on the asset class.
Traders Find Less Competitive Niches
You wouldn’t open a coffee shop next to Starbucks.
Rather than investing in the highly competitive US Equity options market, traders can choose to look at smaller niches. For example, a trader friend knew someone who decided to focus on sports betting, specifically taking advantage of the inefficiencies found in obscure fields like Korean basketball. By digging deep into these less-trafficked markets, the trader could spot lucrative opportunities others overlooked.
The primary benefit of selecting these off-the-beaten-path markets lies in the lack of competition and efficiency. Because there is less demand and far fewer players, investors can take advantage of pricing discrepancies or other imbalances normally ironed out by large trading volumes. Markets such as commodities, lesser-known ETFs, and single stocks can be less efficient than major assets such as the S&P 500. There are many opportunities in smaller stocks — with decent liquidity — where large funds may not care to trade.
Conclusion
The mindset of treating my trading operation like a business has shaped the way I see trading. By understanding the market and my place in it, I focused on providing value to the market. This made me confident in where and why my strategies worked.