On Your Marks
Vol #111: January 6th, 2023
Every January the race begins anew. But unlike the starting line at the track, the jumping off point for most of our New Years endeavors is rarely zero.
I’m not particularly keen on resolutions, but I do have goals for this year - some of which should hopefully bubble up in the Till in the coming months! I also want to get more exercise in, but despite my best efforts at the holiday buffet, thankfully I’ve already got a decent framework and motivation in place.
Investors like the idea of starting the new year with a blank slate, but it’s never truly wiped clean of past histories (which is both good and bad for my mile pace). The amount you start with also happens to be the amount you finished with last year. Every trader begins their fiscal year with a goose egg, but their long term track record will dictate more about their relationship with the risk department than the first few runs of PnL.
It would be naive and myopic to make judgements on just a few snapshots. When managing traders, we never had a fixed rule about stop losses or how much money you had to lose to get fired. A lot depends on the “path”. Lose $100k on a pharmaceutical stock jumping 50%? That sucks, but hopefully it was a calculated risk. If you lose $5k consistently every day for a month then something is probably broken in your process.
The path that the broad market took last year was volatile. We can describe this by the S&P 500’s range (1300 points), the average VIX reading over the year (25), or even how much Bitcoin fell (64%). But nothing imparts the detail felt by those close to the heat of an interest rate paradigm burning down. The closer you were to that flame, the more frequently you were emotionally marking your position.
All of these stats are based on where the books closed on December 31, 2022. For accountants, fund managers, and ultimately the IRS, what your position looked like on that fateful day is all that matters. The “mark” is what you get compensated on, and combined with your actions throughout the year, determines how much you’ll pay in taxes.
Active traders must constantly review their marks. Monitoring position values is how you know if you’re operating a profitable business. A simple end of period summary doesn’t capture the difference between the two traders described above. We need more detail to better shed the losers and spotlight potential optimizations.
The methodology for gathering marks will depend on the use case. If you’re only interested in a high level overview of your stock and bond portfolio - monthly and quarterly does the job nicely. Stocks have a final closing price that is well valued by billions of dollars of capital. Options are slightly less liquid, and the standard is taking the midpoint of the bid and ask price.
There are certainly bad and unfair marks that happen, but for the most part this practice works. Market forces are powerful, and quickly realign mis-pricings. Market makers or large institutions can certainly nudge prices temporarily in their favor, but that game will only last so long. And if you think a mark is unfair, but it persists for days and weeks, it’s time to adjust your inputs.
Broadly speaking, a market maker has two responsibilities; managing the current inventory, and selecting what new positions to warehouse. When evaluating individual trades to determine price and sizing, how that trade marks out is very important. Post trade, you want that option price to stay relatively stable, and the stock trading close enough to get your hedge.
To trade better, we need to dig into all of the components of that trade and marking lifecycle. Was that orderflow benign or toxic? Is the stock algorithm trading effectively? Why am I not making more money?
The equities and options markets are a complex and interwoven network. The simple model is you call a broker and they walk on to the NYSE and ask how much for 1000 shares of GE. This model commutes well to the digital world where you simply push a button and magic- confetti appears. What goes on under the hood is a lot of hot potato routing and fee optimization across dozens of public and private networks.
In 2005, the SEC implemented Regulation NMS (National Market System), a rule designed to level the playing field across equity trading venues. Stock trading has a long history of shady fills. There was collusion amongst brokers who would only trade at round ticks, and the SOES bandits who took advantage of early electronic markets. By the early 2000s, anyone with a server rack could spin up a new trading destination that was only lightly regulated.
Reg NMS means that any venue which has achieved exchange status must be considered at the same priority level, and brokers had a fiduciary duty to route orders to the exchange with the best price. It further dictated how “off exchange” orders in dark pools could be reported, This expansive foray into microstructure rule making was a first for the SEC, and came with unintended consequences.
The years following Reg NMS were rife with new examples of systemic abuse, resulting in the demonization of high frequency trading. Some of the activity was clever liquidity provisioning from faster and richer firms, some of it was privileged access to off the record order types. While much of the nefarious activity has been stamped out, we’ve been left with a technically complex equity market landscape.
Some of the biggest equity traders are options traders, because they need to hedge their positions. In a perfect world you’d sell the call at $1 to one customer, and then turn around to buy it back for $0.90. The reality is when you sell that call, you buy stock to hedge the delta risk, and move the rest of your pricing around to demonstrate a bias to flatten or manage other greek risks.
In open outcry, it was a race to get the hedge off (not too soon though, or compliance starts knocking). As more trades happened electronically, there was strong demand to build tools that would hedge automatically. In one of the weakest attempts at psy-ops ever, our traders and support staff were instructed to refer to the “auto-hedger” tool as “the gardener” on the floor so that the competition didn’t know what we’d developed.
For a few months, maybe a year, this worked well in most circumstances. An options trade would get reported, and boom a hedging order went out immediately. Buy 10 calls, sell 500 shares. Lock in that edge with a hedge.
In order to ensure they would get a fill, traders would start putting in offsets on their orders, being willing to pay up .01 or .02 and flatten the deltas they just traded. As equity HFT got more sophisticated, this “naive” orderflow was ripe to take advantage of. This was particularly true in thinly traded names where options markets provided more liquidity than the underlyings. Derivatives traders are smart people, but their hedging flow tends to be dumb because it’s mostly reactive.
When our savviest trader started paying close attention to the equity orderbook, he realized much of our flow was getting ripped off for fractions of a penny. We needed a better way to trade equities, and the booming business of execution algorithms was waiting with open arms.
The value proposition was clear: send an order to an executing broker's algorithm, and they’ll use historical data, physics, and astrology to get you the best possible fill price. The basis points you paid for this were a fraction of the potential cost savings (proven through TCA). Brokers hired PhDs and quants to develop methods that analyzed a thousand points of light for your trade in real time. Minimize your footprint as much as possible, don’t move the mark.
The science of studying execution performance is referred to as Transaction Cost Analysis (TCA), and seeks to detail how orders compare to some benchmark. This could be the close price on the day, or the volume weighted average price during the execution window. If a fancy series of pings and order slices could beat the average market price, it was worth your money.
The goal was to come as close to scratch as possible. Every order will impact the market price, no matter how infinitesimally small. If you sell a call, for every penny the stock ticks up as you buy stock to hedge, a bit more edge is lost and the mark gets a tad worse. You want to sell just enough calls to maximize the edge captured, but still be able to get your stock fill.
Mark outs also matter on the options leg of the trade. Stock and option prices move along one vector, but there are other inputs that will impact the value of your derivative. Assuming you got a hedge off, the option you just bought could go up or down for other reasons.
Customers selling options are supplying volatility exposure to the market, so the implied future variance should go down. If they’re selling puts, it could further mean a supply of rho, or interest rate sensitivity, suggesting interest rates might be going up.
The best mark out is one that doesn’t move, and the edge is stable. These were the trades that everyone fought over. Buy 1000 calls on the bid, sell your stock at the market, and the spread doesn’t move - that was every trader's dream.
The marks don’t shift when the orderflow doesn’t drive any change in valuation. A toy store doesn’t think twice about a random mom or dad coming in to buy a set of Legos. They might double check their inventory and price when a suit comes in to buy 100 at a single clip.
As new trades become old positions, the trade lifecycle moves forward. Your net stock position from delta and gamma hedging collapses into a single line item, and all the options you’re long and short get marked at the midpoint. Time passes as volatility ebbs and flows, requiring subtle tweaks and position pruning.
If everything goes according to plan, the thousands of little pennies of edge start to collapse around a settlement value. Expiration is the ultimate mark, where calls and puts are absolutely in or out of the money. But whether it’s contract expiry or a periodic closing of the books, marking is more than an exercise for green visored geeks, it is a critical component of performance evaluation.
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