Independence Makers
Vol #136: July 6th, 2023
If Memorial Day marks the start of summer, the Fourth of July marks its coming of age. The adolescent season is bursting with the kind of hope and energy that only lazy days can inspire.
The American forefathers did well to coordinate the timing of the Declaration of Independence with vacation season. Of the sixty odd nations that have since separated from the United Kingdom, July is the second most popular month, bested by August and October. Spring is slow, but then over 50% of the revolutions declare their independence between July and October.
The revolutionary ideas of capitalists and socialists alike have inspired men to take up arms to improve their lot. Independence brings the ownership and autonomy required to achieve this goal. Then come the fireworks.
The Fourth of July is a good holiday to celebrate. It brings no gifting requirements or stormy travel season. Celebrate with friends or family, franks or beans. The backyard burger vibes echoing with John Philip Sousa tunes proclaim our collective belief in the American dream, while kindling our own self resilience. Freedom sizzles.
Independence means different things for different people. Whether it’s sparked by taxation frustration or the search for religious freedom, nations yearn for sovereignty. On an individual level we seek our own autonomy for distinctly personal reasons.
Trading is a domain which rewards independent thinkers. The risks that are well understood offer meager rewards. Contrarians pay the cheapest prices. The spirit of the old man against the sea rages inside every person who has tried to match their wits against mother nature’s markets.
Early opsie dealers in Amsterdam or the shogun on the Dojima Rice Exchange were independent businessmen. They staked their own (or borrowed) capital every day to punt and be punted. No army of quants to code their execution algorithm or sales traders to bring them flow. You were your own bookkeeper, broker, and bail bondsmen.
The floors of the CBOE, AMEX, and PHLX exchanges were heavily populated with “locals” in their early days. All it took was a cursory floor test, seat lease, and a six figure deposit into a Merrill Lynch account and you had an insider’s crack at orderflow from the heart of the lion’s den.
Passing the floor test made a driver’s license look like a MENSA application, so the hard part was always capital. Fortunately the potential rewards of being an on floor liquidity provider were well known, and there was a cottage industry of backers willing to give aspiring Masters of the Universe a little bit of leverage in exchange for a cut.
The texture of these deals was as varied as the jackets the traders wore, but it fundamentally comes down to how to split the pie. A backer could turn your $50k into $250k, which gave you enough haircut to trade the first couple months of an interesting product. You couldn’t sell VIX calls or TSLA LEAPS, but it was enough leeway to make some scratch. The first $50k you lose is yours, and your backer keeps 10-50% of your profits. This varies based on past performance, earnings tiers, and capital size.
Self backed traders had no risk management other than their clearing firm’s liquidation department. You had no boss to answer to other than the bottom line. This was liberating in that you didn’t have to come in early on Tuesdays for a risk call, but you also didn’t have someone double checking the dividend after you just sold a clip of puts.
Locals could also get away with trades that larger firms might not necessarily allow. Compliance is an exercise in parsing gray into black and white, and every firm has their own culture of subjectivity. The bigger you are, the tighter your filter has to be.
Dividend plays were one of the trades that large firms started shying away from after the regulatory ombre offered shaded guidance. The crux of this play is capitalizing on customers that don’t punch their calls ahead of a dividend. Stocks pay a dividend, calls don’t; so if you want to get the distribution you need to own the shares on the record date. By trading large size in call spreads back and forth, market makers could take up a significant portion of the open interest with no true economic risk and capture outsized benefits from the customers who didn’t punch.
There was significant back office risk here (what if your own trades didn’t punch?) and it also looks designed to simply paint the tape and take advantage of unsophisticated participants. There was no hard and fast rule though, so locals continued to gobble these up for several years.
Backing a set of independent traders was interesting to investment capital, because it offered a degree of diversification. OCC volumes are always a macro factor in the industry, but ten knuckleheads making coinflips with 51% odds was better than just one.
Moving up the spectrum from the pure independence of an island nation with a robust food supply, trading firms could organize around not just capital but infrastructure. When the most sophisticated technology required was an HP 12C and dot matrix strip of theos, the overhead costs were negligible. A single liquidity provider today, even in a shared infrastructure, needs to clear six figures a month to cover costs.
You can’t share market data - NYSE and NASDAQ have the hounds loose - but you can share server racks, negotiate software licenses, and split engineering time. One clerk can do the stock execution and trade breaks for a dozen traders. A single data analyst can monitor news events, dividend changes, or earnings announcements for an entire firm.
The evolution of options liquidity provision into a battle for pennies and PFOF has meant that most independent market makers have gone away. Pod shops and order flow monsters have replaced the pit warriors battling for their own accounts.
Market makers are unique in that they sit in a privileged position of structural alpha. Their status grants them specific rights and access to order flow that other participants do not have. This exists on a microstructure level for orderbook interaction, but also on a regulatory level with exemptions for short stock failures, or favorable capital requirements. However as the economics of this business tilts distinctly towards scale and away from sole proprietorship, it has opened up new potential opportunities for independent traders.
The tighter markets that result from increased competition amongst liquidity providers means that retail traders have never had better access to trading opportunities. It’s senseless to compete with market makers for “edge” vis a vis the bid/ask spread, but combining research acumen or tailored objectives with deep and liquid options markets opens up significant, and significantly cheaper investment opportunities.
Like the locals of yesteryear, retail traders can access certain pieces of edge that large scale market makers ignore. As traders, they can capture small price inefficiencies that aren’t worth it to big firms. When I first ran test trades in early listings of Bitcoin futures, even though we made about $70 on a coin, only 500 coins traded a month. $35k of “total addressable edge” doesn’t pay the lease on LaSalle street, but for only a few hours work anyone with an internet connection could have gotten 10% market share. These same types of opportunities still exist today in a fragmented crypto landscape with different pools offering different pricing for arbitrageurs willing to do the leg work.
Beyond trading opportunities, independent investors also benefit from this market evolution. Costs are the greatest friction for any strategy, and as execution quality continuously improves investors can apply the surgical precision of options strategies at lower and lower costs. Rebalance timing is a catch for any strategy that relies on time, i.e. options. If you can neutralize this by trading more frequently at little marginal cost- e.g. rebalance 8% of your position monthly, rather than 100% annually - it’s a major win.
Independence is a powerful thing. It is a double edged sword of privilege and responsibility. Sovereign nations have the power to make their own laws, but must enforce the security of their borders. Sole props don’t have to argue about short vega in NFLX, but don’t get the water cooler conversations about what new biotech is trading.
Flame kissed autonomy tastes delicious, but ironically, it’s best celebrated with others. There is a saying that concentration builds wealth, but diversification preserves it. I think you could replace concentration with independence.