Hedge the edge for leverage
Vol #251: November 13th, 2025
Specialists, are special.
They’re the only traders on the floor that have their own private area. Room for clerks alongside them and a counter in back for yesterday’s sheets and pizza boxes.
They’re also called the Lead, or Designated Primary Market Maker. Traders with increased responsibility and greater participation rights. They are the buyers and sellers of last resort.
In some cases, before any market maker can submit a quotation, the specialist must open the product.
In the olden days they were also responsible for matching closing orders, or executing a customer order. Stack up the buys and sells to maximize vig. The broker was guaranteed to hear you, maybe whisper a side bar, unlike for the new guy in the cheap seats.
Today the benefits are niche electronic order routing preferences, where they can direct one lots to themselves. Cover one exchange for every product and you can scoop all the benign flow.
Exchanges will only give these roles to established firms. The allocation process was opaque; it was partly performance based (i.e. tight and regular quotes), it was partly how much business you brought to the exchange, and a little bit of sprinkling the infield for optics. Premium products could swap specialist posts in eight figure deals. It pays to be the big guy.
Downstream firms would always pass the rights along to the top traders. The internal competition was fierce. I can name more heated fights about DPM rights than I can about comp levels. Though there were plenty of both.
Even within teams that shared PnL there was territory marking. Because everyone wanted to be the guy that traded the big name. Someone who could handle two Escalades and a couple condos in Long Island. Before you knew how to trade, you knew the juicy rumors. Listen to what that guy says, I heard someone jumped in a pool at his wedding.
New clerks start up in the booth, or even better off floor, where they can learn some of the ropes. A little bit of addition and button clicking sounds simple, but it takes on a whole new magnitude when done under the pressure of a trading pit. As luxurious as those private cubbies sound, there wasn’t room for stupid.
The first few times I got to stand there I kept my head down and focused on not screwing up. A couple orders got moved through the ANTE terminal and I even caught a broker’s quantity where another clerk didn’t. Another day of making it to mock unscathed.
TGT (Target) wasn’t listed at our post, but traders increasingly had access to remote opportunities as exchanges opened up their electronic books. It was a slow day, and our spec must have decided to take the order out of boredom. (Not a great way to trade!)
Someone wanted to trade a deep delta option, and markets were fairly tight. But rather than bang out stock right away and lock in a penny, Mr. Big Shot wanted a little more. Not quite in the same way the risk desk would ask, but I was curious - “why aren’t you covering your deltas?”
“Why waste the edge with a hedge! Haha!”
Obviously (?) he was joking, but we all watched as he picked away at 10,000 shares, living and dying by every tick. I never saw the PnL, but I think he made a few extra pennies on stock buys. For a whole lot of effort and stress.
Adding a little more excitement to your day isn’t a good reason to let deltas run. This was an oversized play account trade. But the phrase resonates with anyone who’s traded as a market maker or portfolio manager. For both trading styles hedging can be a significant cost, why do we bother?
Options dealers hedge their books mostly so they can reduce the PnL variance. Even if you’re trading a million contracts a day, they’re not all going to perfectly offset, and collecting 110 pennies to lose a dollar is a choppy way to live life.
The business here is edge collection from pricing the implied volatility of options and warehousing the positions that customers choose to buy and sell from you. The hedge is everything you do with adjusting pricing, trading underlying stock, and buying or selling nearby options.
Hedging your book locks in profits. The edge is the hedge; the ability to manage and contain vast dimensions of risk that net into consistent profits. Dealers are nothing if not hedgers, which is why it’s rather droll to track their movements for your own edge. You’d be better off mainlining TGT deltas.
Not every hedge is black and white. Whether through delta tolerances, or periodic timing of position reviews, tactically applying the hedge is part of the art. Hard deltas (like a deep ITM call) probably require stricter and more urgent hedges than the vacillations of greeks from the natural ebb and flow of the market.
Portfolio managers think about hedges in different but similar ways. Bonds offset equities in a 60/40 portfolio because they have a different stream of returns and sensitivities to the typical long cycle of events. (Plenty of caveats there, but that’s the basic point.) Basic diversification is the original hedge.
An options strategy can be the hedge itself. Look at an equity chart over the past two decades and you’ll quickly find three or four points in the curve where there’s universal agreement - “how do we protect against that?” No one wants to hear that costs money, so bonus points if you can get your hedge for free.
Most options strategies that target the variance risk premium have their own similar curve. The times when condor selling, short skew or puts blow up, are right in line with when indices head south. Equity and variance risk premium tend to come due at similar times.
Managers are constantly seeking that white whale of low cost and high impact because it offers them a powerful tool. Leverage. 3% a year with a 10% max drawdown sounds “okay”, but I’m probably not selling my bonds or equities for that. If you can cut the drawdown by half with a hedge, now with some margin you can double the return for the same drawdown. More if you cut the tail even tighter.
If your edge is real, you’re going to want to hedge it. Nothing that is true in financial markets is certain, and you need to plan accordingly. But if that is real, it’s something you can build on and scale. No matter what your business model is.
Hedging provides consistency, and consistency delivers profits. Profits let you pop bottles. Even champagne is a hedge. Take a mediocre and inconsistent white wine region, start blending it across a few years and parcels, add a bit of dosage, and voila. Dom Perignon makes upwards of a million bottles for every vintage.