I think you are correct, up to a point. As long as there is vicious price competition and transparency,
The world out there now is Terra Incognito to this old CBOT Bond Options trader. (Retired in 2000). But, I started in the pit in 1984, when volumes were light, spreads wide, and it wasn't crowded. Obviously, over the years the volumes grew and spreads tightened. We were one of the first small (but growing) groups to use delta based hedging and vegas and gammas (I'm sure they're called something else now) for portfolio management. Because, as you say, it's all about inventory management. We would often carry up to 100,000 options overnight, delta and gamma "hedged" (as you know, there truly are not real permanent hedges for options; just temporary ones). We were just edge-gatherers. Trying to stay delta and gamma neutral by the end of the day. As the volumes increased and the edges shrunk, we once calculated that we were getting 1/3 of a tick (a tick in the options being 1/64th, or $15.625) per trade; but if you traded 15,000 to 20,000 options a day, as several of us in our group did, that could add up. Of course, there almost always seemed to be slippage overnight on this, but still.
We innovated in some ways by using adjusted deltas and gammas for the more OOTM stuff. Instead of using the BS deltas and gammas, we used the deltas and gammas on the vols that those strikes traded on. (Skews and smiles and all that.) It seemed to help more often than hurt.
We also did something few others did. We took the far tails out of the model, since the models failed for these way OOTMs. We manually offset way OOTM shorts w way OOTM longs. Never came in in the morning with a huge overnight move and faced a large drawdown. Often quite the contrary. Naked tail sellers got away with it for a few years, and then got wiped out. But, the banks that backed them had already paid them out for the previous years, so they didn't care. We traded our own capital.
Anyway, thanks for prompting a trip down memory lane. Grateful to be in the right place at the right time. In retrospect I suspect our volume explosions were created by the explosion in FNM MBS issuance and guys using our pit to offset their embedded short option exposure.
This is fantastic history! Thanks very much for sharing. In many ways very little has changed in the ethos of edge gathering, just the different techniques and trading mechanisms.
I strongly agree with your initial comment about "as long as there is vicious price competition and transparency." Much of my faith in that is based on the competitive and regulatory dynamics that force the smaller number of participants into fierce competition. Auctions, crossing rules, etc.
I think you are correct, up to a point. As long as there is vicious price competition and transparency,
The world out there now is Terra Incognito to this old CBOT Bond Options trader. (Retired in 2000). But, I started in the pit in 1984, when volumes were light, spreads wide, and it wasn't crowded. Obviously, over the years the volumes grew and spreads tightened. We were one of the first small (but growing) groups to use delta based hedging and vegas and gammas (I'm sure they're called something else now) for portfolio management. Because, as you say, it's all about inventory management. We would often carry up to 100,000 options overnight, delta and gamma "hedged" (as you know, there truly are not real permanent hedges for options; just temporary ones). We were just edge-gatherers. Trying to stay delta and gamma neutral by the end of the day. As the volumes increased and the edges shrunk, we once calculated that we were getting 1/3 of a tick (a tick in the options being 1/64th, or $15.625) per trade; but if you traded 15,000 to 20,000 options a day, as several of us in our group did, that could add up. Of course, there almost always seemed to be slippage overnight on this, but still.
We innovated in some ways by using adjusted deltas and gammas for the more OOTM stuff. Instead of using the BS deltas and gammas, we used the deltas and gammas on the vols that those strikes traded on. (Skews and smiles and all that.) It seemed to help more often than hurt.
We also did something few others did. We took the far tails out of the model, since the models failed for these way OOTMs. We manually offset way OOTM shorts w way OOTM longs. Never came in in the morning with a huge overnight move and faced a large drawdown. Often quite the contrary. Naked tail sellers got away with it for a few years, and then got wiped out. But, the banks that backed them had already paid them out for the previous years, so they didn't care. We traded our own capital.
Anyway, thanks for prompting a trip down memory lane. Grateful to be in the right place at the right time. In retrospect I suspect our volume explosions were created by the explosion in FNM MBS issuance and guys using our pit to offset their embedded short option exposure.
This is fantastic history! Thanks very much for sharing. In many ways very little has changed in the ethos of edge gathering, just the different techniques and trading mechanisms.
I strongly agree with your initial comment about "as long as there is vicious price competition and transparency." Much of my faith in that is based on the competitive and regulatory dynamics that force the smaller number of participants into fierce competition. Auctions, crossing rules, etc.