Knock knock, it's the stock cops
Vol #233 - July 10th, 2025
Police still there?
When Google Maps asks me to confirm whether there’s police activity, I try to genuinely answer correctly and aid my fellow drivers. So imagine my surprise when I sat shotgun to a friend who falsely reported that there were cops still present.
“That way people slow down anyways.”
Hmmm. I think a little bit of speeding helps the roads move along. While speeding to the point of increasing traffic fatalities is objectively bad, a row of jammatrons all moving at exactly 55 MPH isn’t exactly an efficient use of the roads. Don’t you flash your headlights to other drivers when you see a speed trap?
Agree to disagree, there are objective laws that can be enforced if you happen to miss the new tech or old school tip off. Just be as nice as you can to the office.
That rule of law will still bend in different directions depending on who’s interpreting it. Even the simple notification in the app starts to tread into a grey area. NYPD once sent Waze a cease and desist for alerting drivers of DWI check points. Not legal or financial advice, but roughly the first amendment allows you to report public activity, but it starts to become interference if you’re directly involved in a crime or encourage illegal activity.
I’ve always wondered why these apps aren’t better. Crowd sourcing the data is a challenge I’m sure, but I also suspect there’s a line big companies are just not willing to cross. If the app was too good, it’d start to look criminal. And you make more money not being labeled a criminal, regardless of what you’re doing.
I didn’t expect to have a follow up to last week's post so quickly, but a fascinating case of parasitical edge (maybe?) was released only hours later. Jane Street’s temporary ban from Indian securities markets has introduced a lot of volatility into the variance community.
In their complaint against the Jane Street Group, the Securities and Exchange Board of India (SEBI), lays out some damning allegations that look like pure market manipulation. Cast through a different light, this is just traders making markets.
The basic accusation is that Jane Street took advantage of the massive liquidity mismatch between stocks and options to manipulate the prices during the day, but also importantly at settlement. SEBI points to the fact that their trading activity was significantly higher on these expiration days, as well as the manner in which they executed orders to demonstrate the nefarious intentions.
Why someone is acting the way they do in a market is very difficult to determine. Matt Levine makes this excellent point, that just looking at the paper trail isn’t enough.
I suppose the main point here is that, in many cases, “legitimately doing an arbitrage trade” and “trading in one market to manipulate prices in another market” look pretty similar. Either way, you are trading the opposite way, buying stock in the stock market and selling it in the options market or vice versa. The difference can be subtle, and I often joke that the difference between legitimate trading and manipulation is whether you send your colleagues an email saying “lol I sure manipulated that market.”
Every trader of derivatives has observed this liquidity dynamic. When one security is inherently linked to the price of another, movement in one ripples into the other. Orderflow and microstructure dynamics may create temporary dislocations, but it’s the job of active participants to close them.
In this particular case, the gap was significant. Options trade roughly 353x notional compared to underlying stocks. There is a robust retail community that actively punts these for fun and tax deductible losses. On the main date in question (Jan 17. 2024) the index opened down 3%. Big moves like that tend to create larger gaps in these arbitrage relationships, and put call parity priced the options implied index level almost 1.6% higher than cash markets.
In this scenario, it is completely reasonable to be a seller of calls and buyer of puts. SEBI however finds fault with the hedge ratio, as Jane Street sold 7x the number of deltas with options compared to the stock they were buying.
As index arb veteran Tina (@moreproteinbars) points out, fading the deltas of a customer that seems biased (and naive) is the way a savvy dealer operates. Especially going into a same day expiration, where short market exposure expires into cash at the close. It even makes more sense with the index trading at the given level relative to options, and if you have an understanding of how much even a small hedge moves the underlying.
SEBI leans strongly on the idea that the price taking behavior of Jane Street in their equity trading shows they were attempting to spook the market. Lifting offers and paying up has the effect of causing liquidity to quickly fade in one direction. Size moves markets, but how you show that size can be even more informative.
Yet I don’t find price taking from a dealer to be categorically bad either. Market makers provide liquidity by making more trades than just selling offers and buying bids. In order to manage a risk book they will take liquidity and find ways to spread around their risk in similar or related products, be that the underlying or other options.
Taking price may also be an expression of urgency. They need some deltas to offset their risk, and exposure that comes from a trade is usually hedged quicker. Further, if there was an arbitrage gap with the implied price of the index they would want to trade aggressively to close that. When the gap is huge, you have permission to trade it sloppy.
A more nuanced take on this arbitrage point comes from a fellow participant in the Indian options market - Alexander Gerko of XTX. He argues that even though this arbitrage is a fair reason to trade - with Jane Street’s nefarious activity the result is not a convergence towards equilibrium, but some shifted version that was determined by your impact.
As a thought experiment he proposes the idea of scaling your strategy down by 100x and seeing if it has the same results. If the edge you are realizing is because of your market impact, you’re treading into dangerous waters.
The tension is so great here because of the ambiguity. Every order naturally pushes the market in some direction because that’s what price discovery is. We want free and transparent exchange that allows for risk transfer and incentivizes participants with dollars (rupees) to provide liquidity and keep prices fair. It’s not a problem if you intentionally act in a way that creates as little impact as possible (VWAP, implementation shortfall algorithms), but intentionally creating impact is a big no-no.
Since everything comes to a head at expiration, the trading activity around the closing price is even more suspicious. With options settling based on a final print, there is some truth that everyone has to agree to at a fixed time, there’s no more price discovery after the bell.
“Banging the close” is the term used to describe how aggressively trading one leg of a settling derivative can push its close price in a direction that favors your position. Even easier if your position is multiples bigger in the options and the underlying is slippery.
Similar to their other activity, you could explain away some of Jane Street’s transactions by suggesting they were closing their expiring deltas. There are real risk considerations to making the trades they did. There’s a decent trader debate that would argue the better way to manage this expiration risk is to get your deltas elsewhere, and thus trading the underlying shows nefarious intent.
Even for those that can justify this activity during the day, manipulating settlements draws the ire of almost all traders. To the equilibrium point, an expectation of trading is that settlement will be “true” and you can use your models to price whether implied volatility is high or low. If someone is artificially nudging that, there’s going to be less interest in trading the product and liquidity follows a downward spiral.
There’s no shortage of responses to these accusations that suggest this kind of activity happens everywhere - why is this one such a big deal?
This does happen a lot. And often what looks like manipulation to one observer is simply a participant acting within reasonable bounds. Other times it is done with the intent of manipulating the game. I know because in another life I’ve been pitched strategies that proudly claim to take advantage of the liquidity mismatch. We didn’t hire that trader.
Absent discovery of some damning IM messages, we’ll never know what the true intent of the trading group was. I’m not even sure it matters. What’s important now is the perception and ignored guidance.
Securities regulation has the thorny problem of parsing what is good and bad engagement. Because if someone is truly manipulating markets and taking advantage of others that’s a problem. They have broad discretion in calling out something as manipulation, because it’s so hard to write precise rules about this. No one likes to be on the other side of regulation by enforcement action, but I’m not sure there's a much better choice.
While the notice came out last week, Jane Street has been interacting with the regulator since August of 2024 on this topic. Usually when someone starts sniffing around, it's a sign that your strategy might be getting a bit too cute. Regardless of your altruistic conviction as a white knight participant, if SEBI doesn’t like the cut of your jibe it’s time to do some serious thinking.
Whether it’s a ref in basketball or a cop on the highway, the enforcers often have a lot of discretion. Maximally extractive strategies are frowned upon, and will land you in the penalty box. Each firm’s culture responds differently here, but it's paramount to every prop shop to understand the regulatory dynamic they’re operating in. (Kris makes a similar point here.)
An important part of being able to make money as a trader is protecting your balance so you can always take another shot. You also need market access to do that. Trade smart and aggressively, but be keen to the non-price signals your strategy is kicking off.