Almost Rational
Vol #120: March 9th, 2023
There’s both art and science to any endeavor worth pursuing.
Highly quantitative professions require qualitative craftsmanship to develop elegant programmatic solutions or isolate an element of scientific progress. The most right-brained creative must also gain some proficiency in the chemistry of paint mixing or object rendering in Photoshop.
The best musicians bring soul to their performance. It’s not the simple mechanics of passing exactly the right amount of air over the reed, but the subjective and often improvised elision of certain notes and staccatoed exaggeration of others. Lazy pianists can lean heavily on the damper pedal to artificially blur this affectation.
As a perpetually recovering practitioner of the art of trading, I have always had a great deal of respect for the ying, yang, and je ne sais quoi that this profession ceaselessly demands of us.
The speedrun natural selection of a dollars and cents world is merciless in its perpetual attrition. Like the NFL combine or the college admissions process, what the scouts see on paper rarely tells the full story. There are as many #1 selections that stumble as there are 199th pick Tom Bradys.
Selecting, training, supporting, compensating, and retaining exceptional traders is the alpha (and omega) of successful trading firms. It’s not by accident that Citadel Securities has the most stringent non-competes and also systematically makes it rain in whatever asset class they touch. Or the fact that there are a half dozen firms you’ve never heard of that are home to nine figure producers you’ve definitely never heard of.
The candidate review process is the first rough cut by a relatively arbitrary sorting hat. Nail the Bayesian interview question, talk about how you went to states in sport X or have demonstrable talent in challenging thing Y, try to look the part of a baseball guy - the job’s yours.
There’s a distinct relationship between raw intellectual horsepower and eventual trading success, but the slope isn’t as steep as those with strong independent variables would like to believe. The mathematical baseline for being a good trader is several rungs below differentiating the Black Scholes model.
Many people have pointed out the hunger aspect. This is table stakes for a game that demands a high tolerance for intellectual humbling and emotional fortitude. Almost 42 years ago Alan Greenberg described his hiring techniques at Bear Stearns in a memo to the partners. They were looking for applicants not with an MBA but a PSD - “poor, smart, and a deep desire to become rich.”
Once you’ve selected for smart, competitive, and even the deep desire to be rich, the process has just begun. With months of training and shadowing, tea is made, the herd is culled, and a small fraction of those who set out, remain. Mock trading is where the most insight is gleaned, but analysts are also judged by the quality of their market recaps, the insight of their questions, and even how well they do at lunch runs.
It sounds like an old school floor trader hazing to make the analysts do lunch runs, but this tradition has sound underpinnings. Most traders need to eat and are hopefully too busy to get up. But how well someone can remember six different salad toppings and deliver the correct change says something about grace under pressure. Giving bad change was a fault, but deftly scalping a group order to get yourself a free lunch was silently commended.
The decision making here often felt very subjective. There’s a lot of “he doesn’t get it” or “she’s ready to go on a badge” that was about far more than the score on a test or list of skill proficiencies. There was usually consensus around the hard yesses or hard nos, but a good day or bad day in mock could nudge someone on the fence either way. A bungled Fontano’s print was a death knell.
When a trainee can demonstrate that they are able to blend the art and science of the craft, it’s time to put them to the test behind a machine under live fire.
The definition of “it” in this context is much like trying to pin down what is pornography. You know it when you see it, but it’s hard to describe exactly. It’s looking over a traders shoulder and asking about why something that is curiously out of line, is out of line. It’s having an order by order conversation with the mock leader, straddle swapping over your peers' heads who haven’t quite caught the theme.
I recently saw a quote that helped me frame what that certain quality was. Hat tip to Bob Seawright and his Better Letter for quoting GK Chesterton’s “Orthodoxy”.
“The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.”
The best traders all share the ability to avoid the traps of pure logic, and exploit the hidden inexactitudes of the marketplace. Some of the hardest things for the biggest brains to wrap their heads around is the parts of trading where it’s irrational.
Computerized trading dominates most asset classes, but those programs are written and constantly updated by very smart humans. Machines can do a lot of arithmetic very fast, and aggressive pits will smash a bid before you blink, but it’s the fuzzy logic of trader spidey sense that glimpses the hidden wildness before selling hundreds more corporate action stubs underwater.
To make money trading options you need to buy when volatility is cheap and sell where it’s expensive. But you also need good access to stock borrows. This loan shark world of market makers captive to their clearing house’s backoffice machinations was its own game to play.
Good traders didn’t just collect the most edge, they positioned themselves to be the most competitive when it was the most lucrative. Stocks that were hard to borrow were good to trade because a heavily shorted float meant that vol surfaces would bend in interesting and exploitable ways.
The catch with hard to borrow names is that sometimes there would be “fails” or failure to deliver notices. Ultimately shorted stocks are borrowed from someone who is long, and if they want to call that back, the borrower who sold short has to buy that back. Under the prior system, there was a clock that started ticking after the first fail, and gave you 14 days to cover.
Clever traders would time their positioning in products to take advantage of these clocks. If you patiently lay in wait while everyone gets short first and their clock is running a few days ahead, you can step in to sell the top once everyone else is wearing the risk and regulatory handcuffs.
The trainee that never goes hungry on a lunch run, or that coyly fades their markets during mock is much more likely to play the Reg-SHO clock game well.
Analysts would be hammered with the mantra of “trade/hedge/fade/repeat”. The basic process of updating markets was Mock 101. When you’re on an actual trading machine, this turns into something more like refreshing the fit on your vol curve and making sure your automatic hedger didn’t whiff on stock.
Simply doing these rote tasks well isn’t going to make you much, if any, money. While we all have auto-fitting tools, blinding painting your vols to mid-market will mean you’re always a step behind. The scripts will make sure you don’t get picked off on stale quotes when stocks tick up and down, but it takes an ability to recognize the illogicity in a logical marketplace and proactively raise your skew several clicks through the marketplace offers.
Every trade that hits the tape has an impact on the market, slightly shifting the consensus view on the future distribution of stock returns. These are mostly done by actors behaving rationally, recalibrating their risk. But if you can find the wrinkle lying underneath, yours is the Earth and everything that’s in it.