No coloring outside the lines

Vol #214: February 13th, 2025

“I have this stand, and I’m looking for a bracket that will act like a strap, so I can secure the stand upside down to a rafter…”

The high school clerk is looking at me like I have three heads. My daughter just wants to exchange treats with the cat sitting next to the lollipops on the check out counter. What I need is called a hook, and I am wasting my time trying to explain some Rube Goldberg machine. I should be scanning for the size I want in any of the hundred different little plastic buckets with small metal pieces.

To be fair, sometimes when I walk into Keoughs’ Hardware, a little bit of backstory helps. When an experienced salesperson understands what you’re trying to do, not only do you get your piece faster, you might even get an upgrade. In the right context there’s even a bit of neighborly conversation to have about the upcoming snow storm.

But color didn’t help anyone here. It only puts more time between me and my project. I’m biased to thinking, if somehow I can get my counterparty to understand what I need, this whole transaction will go better. But that’s not quite always the case.

In a land of numbers, context is king. Red bars and green candles, dashboards that deliver insight to executives and executioners alike. You can glean quantitative information from every tick, but the whys are written in words. The romantic je ne sais quoi of what makes prices move.

Take for example the Monday morning VIX bump. Ceteris paribus (an absurdly reasonable concept in markets) the digits are telling you that the S&P 500 implied volatility strip is higher than it was on Friday - vol is up. While this is true, the real story is a bit more complicated. Options pricing models treat decay on the weekends differently, and move time faster into Friday’s close.

While it’s technically the same number of hours, we all know less happens marketwise from Friday to Monday. This clock time bending expresses itself through implied volatility, because the VIX knows math but not context.

A little bit more color here explains the true phenomenon, and will quickly show why you can’t buy VIX on Friday and sell on Monday for a lock. Not only can’t you trade the index directly, this pricing phenomenon is less an arbitrage and more so an efficiency.

In the spirit of the jademaster, improved context comes from time in the pits. Learning from mistakes, soaking up the knowledge. Discerning motivations and deftly wielding the paintbrush with years of experience. Realizing most signals are noise.

There’s only one broker I would call Picasso, but color (or lack there of) as a service is one of their primary job functions. Perhaps coming even before a good fill and a steak dinner.

There are weekly research pieces and daily market commentaries. Summaries of big prints, explanations of J-Pow’s word salad. Politely suggesting the origin of an order in between memes. Information that will entice you to trade. Given enough reasons why, a trader can’t help but lay down a bet.

Trading and color are so intertwined that European regulators felt the need to break up the party. In 2018 MiFID II required that broker dealers “unbundle” research from execution, making it clear to downstream clients of asset managers what they’re actually paying for.

Color doesn’t just generate trading activity (fees), it can actually improve the execution experience itself. There’s the big picture context that generates ideas, but there’s also the details about the why and now of this specific order. On any given trade, the goal is to get the best price possible and often sharing information helps.

Payment for order flow is a perfect example of this. Market makers pay brokers to route and flag orders that come from customers. The ick that many feel about this is misplaced; not only does it come with improved execution prices, there are probably some free tools paid for by the PFOF pools. Self identified color puts you in the priority lane.

Retail traders can even create their own context to improve fills. Orders that flicker on and off mid market, or continually step up every second, signal to dealers that something fishy is going on. Paranoid about adverse selection, what feels like being cute reads as predatory. Prove your harmlessness with a standing order that shows you are not trying to pick anyone off, just get a good fill.

On larger orders, color can also help attract participation. When a broker needs to move 1000 calls in a thinly traded Tier D stock, the best way to improve a fill is by showing the full hand. If this order gets chopped up, the first hundred lot might get a better price, even inside the screen markets. But by the third “how now”, the entire surface has shifted as bids blow through earlier offers. The underlying has probably moved too.

Things start to change when you have a unique kind of alpha. The market is mostly priced for participants that are operating orthogonally. Risk transfers for cash, buyers meeting sellers with different objectives on different vectors. But if you’ve identified a unique mispricing, or pricing is your milieu, you want to keep the color to a minimum.

If your desired size swamps liquidity, and any engagement will be a signal to that mispricing, one must tread very carefully. You can’t announce that entire 1000 lot because everyone will know the dividend moved expirations.

Dealers themselves are very inclined to withhold information. Perhaps the most successful trader I worked with was famously mum to counterparties, whether it was a broker or his CEO adjusting comp. Not a single word or emotion leaked what he was thinking. Generally this characteristic was the norm, not the exception.

In hostile negotiations, any insight gleaned by the other side weakens your position. In a world of information asymmetry where the razor thin markets are predicated on random order flow, everything is a face off. There is never an upside to a market maker explaining their logic or positioning. In order to always be in a position to put up two sided markets, there’s risk management that happens under the hood - you can’t let anyone see that.

When someone knows where your size is, or that you behave in a predictable manner dramatically reduces your ability to be competitive on the next order. Every marginal trade that comes in from the buy side is a new opportunity to collect more edge, but you must be able to compete from a position of strength - a well hedged book where no one sees your cards.

The unique alphas of structural participants are very different from the reasons that most customers and institutions come to the options markets. Imitating components of a behavior outside its appropriate context will hurt your trading on the buy side. Also know that there’s a lot of moving parts you don’t see - intentionally so.

When deciding whether to open your mouth or not, take a look at who your counterparty is and what you’re trying to achieve. The vast majority of transactions are going to be improved by signaling. But sometimes it pays to be tight lipped, not to muddy the situation, or give away any edge.

Color, just within the lines.