Say My Name
Vol #160: January 4th, 2024
The Tenderfoot is the naive early scout, yet challenged by the path of merit badges and jamborees ahead.
But even that first rank is earned. There are 11 requirements, ranging from basic first aid, camping preparedness, to knots and fire safety. They’re not difficult and are highly practical. Nary a month has gone by that I don’t find some use for a taut line hitch.
Before you do that, you’re just a scout. While you’ve had to prove you know the scout oath, most troops wouldn’t allow you to light up a propane stove, and certainly not carry a pocket knife. Rank communicates knowledge and experience, so starting out as the plain noun scout makes sense.
No matter what your degree or resume says, when you start out at a prop trading shop, you’re much less than a Tenderfoot or scout. You definitely don’t know what you’re pledging allegiance to. We were called trainees, and the first couple weeks even that felt generous.
Despite what HR told you in private, there were no intermediate ranks. Trainees became traders. First you trained, then you got on a badge and never stopped learning. Because good traders mostly don’t care what you call them. Mr. Senior Portfolio Risk Manager and Partner, cool LinkedIn, what’s your production look like?
Alas, in addition to trading well, good trading firms need to keep recruiting. Access to orderflow, access to talent, wash rinse repeat. Finding a good trader is as aleatoric as collecting edge. Tinder profiles are more revealing than trainee resumes. But as quickly as they can swipe left, sometimes you miss good candidates because they don’t want the same job title as the guys in Boiler Room.
Blame the trophy generation, but I think this is simpler. You can only throw so much compensation at an unproven probability, but titles are free. If a trainee wants to be an analyst, it takes the same amount of ink and has zero impact on job function. If it doesn’t work out, there are no hard feelings and a less diminutive title probably helps them get the next job. A name and a title can matter, even if you’re still learning to make tea.
All of the different market participants also have their own names. There aren’t that many synonyms for an exchange. It’s a venue. Sometimes a floor. Definitely a market. All connote a place and location for transacting in listed equity derivatives.
The “buy side” of the business - the naturals that bring orderflow, hedging demands, and opportunity - is aptly titled. They’re customers. While there might be sub-categories of active traders, volatility suppliers, or portfolio hedgers, at the end of the day a customer is coming to take immediate pricing. Retail or institutional, they’re just shopping for risk profiles.
When we flip to the other side of the order, there are a lot of different names for market makers. Dress up in a suit and you’re a liquidity provider. They’re the individuals and firms that take the contra side of a customer order.
A market maker is literally someone who makes markets. It doesn’t get more accurate than that. If a customer order comes to the floor, venue, or exchange, MMs have the obligation and opportunity to provide a bid and offer. It doesn’t have to be “good”, but if they want to stay in business it should be competitive. And better priced liquidity is a rising tide that lifts all boats.
How, or why they do this, is illuminated by the myriad of other words we use to describe these players.
Dealer has become the lingo du jour. This is descriptive in that MMs are market participants who deal in options. But it also hints at the type of strategy that most of these providers are playing. And despite what college drinking games taught you, trading equity options is not a face off where you win by F* the dealer. That’s so far from the point.
The casino analogy only goes so far in markets - but it is apt here. A blackjack dealer is a representative of the casino as a business. He has a job to not only allocate out the randomness, but also to play his own well scripted role. A dealer must hit below 16 and stand above 17. His aces always count as 11. Etc.
For a blackjack dealer, each hand is inconsequential. The variance is baked into the business. The actions are perfectly predictable and transparent, and no adjustments for a hot hand or blooming stochastic clouds are made. The dealer keeps moving cards across the table and making rote decisions because it’s what the customers came for. A dealer is only playing the game to facilitate your playing of the game, which has a baked in edge for the house. The business is the castle, not your king.
An options dealer plays a similar role. They put out two sided quotes in SPY that are a fraction of a vol click wide not because they want to sell volatility five points below the 30 day average, but because that and the next million contracts will be at a slight discount or premium to the generally agreed upon fair value at their respective execution times. The orders, not the flow.
At any given moment the most liquid options markets are an incredibly good estimate of what the future price of volatility will be. A dealer is just someone who puts out their orders with a small premium around that and uses the net day trading edge to pay for the costs of managing that inventory. Across a million different derivatives moving in and out of synch.
Because of this, their behavior in the markets by moving curves and hedging deltas is almost as predictable as a blackjack dealer choosing to hit on 16. Any given hand for a dealer is like an options market maker’s open position, over time the goal is to reduce that to net 0. Where you make your money is paying for the castle so you get to watch the player bust first, or paying for the access and infrastructure to trade orders on the bid ask spread.
Consolidators or wholesalers make up the majority of liquidity provider volume, but they are not perfectly synonymous with a market maker. These specific names imply a MM who also intermediates customer orderflow. While bound by the same market forces as all participants, by paying for a further elevated role in facilitating trading, this class of market makers gets preferential participation rights amongst dealers.
The idea of consolidating orderflow gets back to the law of large numbers that a casino operator also leans on. Consolidating risk profiles with all the offsets is of course beneficial to the dealer, but it allows the price of individual pieces liquidity to come down.
Doing this in wholesale volumes is important. With computers doing most of the heavy lifting here, it’s a technical arms race to keep up with the fastest, but it’s also a business that can scale rapidly. Winning market share adds to both the bottom line and diversification.
Venture over to Reddit, and you’ll hear market makers called all kinds of names. But names and titles actually do matter here, because it’s informative about what’s going on under the hood. Dealers, liquidity provider, consolidator, or wholesaler, these fairly literally describe what is happening. It’s as simple as that. (And simple is hard enough.)