Tell Yer Brother
Vol #158: December 15th, 2023
Mock was the gauntlet you ran before they let you into the pits.
This “game” taught you how to trade, fade, and hedge. An instructor would bark orders at hapless trainees who’ve just gotten off a busy day of bungling salad toppings on lunch orders and staring at gaps in log files.
There was a schedule for which traders mocked on which days, but sometimes you got a surprise guest who wanted to vent a little frustration. Each had their own signature moves - like offering puts underwater and berating you for not asking what position limit was. Once you were fluent in reading the setups, adjusting your sizes, and jumping on berries you got badged up.
The cohort before mine had particularly exceptional mockers. Guys who mocked each other for fun and made it look easy. This had quickly translated into on floor success, so us mortals were eager to learn when they descended from Olympus at 86 Trinity. Even if they ate your lunch, dancing circles around you.
The opportunities here were ring fenced. When there’s only a 500 lot on the table, the guy who responds first gets his fill. Battle was straight forward and heads up. You couldn’t afford another guy stepping into a limited resource pool. Even if the mock leaders could print whatever size they wanted, the faster and more experienced trader was going to scoop it all.
This is roughly how competition works under live fire too. A new guy in the pits meant another mouth to feed. You see this electronically as badges swarm to get appointments in the newest hottest issue. Nothing like an upcoming Phase III trial to stack the NBBO.
In the business of trading options, competition means tighter margins and increasingly marginal opportunities. But for everyone else that’s trading options, more competition and more participants make the markets better. And it feeds the virtuous circle that more participation and volume makes it better for market makers.
While an options contract literally puts you on the other side of a counterparty who has a perfectly inverse PnL relationship to yours, you’re not competing with that person. They’ve forgotten you by the close, if not the next tick. You want the market to rise on that cheap call spread you bought, but where the market closes matters little to the dealer.
Market makers are locked in a vicious competition amongst themselves both on and off the screens, but none of it depends on where any given stock lands. It feels iconic to be faced off with your option contract buyer/writer, but lucky for you, the liquidity provider couldn’t care less. He’s focused on microstructure battles to get the most orderflow at the best price.
As more market makers vie for wholesaling opportunities, the demands of brokers can increase. More price improvement, more payment. Most traders would prefer seeing a few marginal pennies on their orders, but a well capitalized broker will build good tools and provide better services.
Competition amongst orderflow consolidators is good for every other market participant. We observe it directly in the tightness of spreads and array of series that are made available. Consumers of options liquidity rejoice as the service providers duke it out to eat more and more of your risk.
There are very few end users of options that should bemoan their increasing popularity. Every retail trader should in fact invite ten of their friends. Tell yer brother, yer sister, and yer mama too. There’s no tragedy of the commons to over consume, or pricing opportunities to squander.
More traders - and particularly ones with different objectives - means there’s a lower cost to providing liquidity. But not just the obvious benefits of scale where if you do more volume your margins can come down. In fact as volumes swoon your CBOE permit fees and AMEX ATPs will probably go up. The real cost of being a liquidity provider is warehousing inventory, and more volume dramatically reduces that.
That inventory has costs that evolve like raw meat on a hot summer day. Customers come to dealers individually for prices on specific series they want to trade today, but broadly their demand is to be consumers of duration. What the customer wants today is pretty easy to deliver and can be done by the greenest of horns. It’s managing that book such that you can readily and consistently deliver liquidity when they want it, that turns streaming quotes into bank account commas.
As a wine collector I have a distinct appreciation for this. It’s easy to look at a restaurant wine list and gawk at the multiples. On the other hand, when holders of greeks walk into an Italian restaurant and there’s a bottle of the 2013 Produttori Montefico ready to decant, game recognizes game. I am more than willing to pay the premium to store and deliver that perfect bottle into the glass with the tiny green sticker. (To denote it from its Barbaresco brethren who were also available.) New wine storage leases start at $0.75/bottle per month, that’s almost $90 of intrinsic value alone.
Only certain places can do that, just as only certain market participants have the balance sheet and business focus to inventory options contracts for an unspecified duration. If a dealer doesn’t know how long they have to hold something, they’re going to give a wide price. If they expect another offsetting order to be imminently inbound, there’s a lot less duration.
Besides just the adverse selection, the capital to support that business is significant. Money itself has a cost, but so does the regulatory infrastructure of being a broker dealer and the compensation for those managing it. Why would you leave a massive pile of bills and liability up to the vagaries of where a stock closed on any given day?
Customers of options should want the best and most fair prices. Volume not only minimizes the per transaction cost, but it increases the efficiency of markets. I don’t think it’s any surprise that in the post-pandemic paradigm shift where OCC volumes effectively doubled, we’ve had some of the closest implied volatility to realized volatility pricing of any market.
Unless you’re in the business of trading, you should be coming to a derivative market to tailor your risk in the underlying. If you’re wrapping your equity position in a covered call or put spread buffer, this is great news. Trading an option will always be a volatility trade. It’s explicitly exchanging some extrinsic probabilistic value for hard cash, thus setting the price of future variance.
If volatility is consistently well priced due to large volume, this removes a major concern. I am making a directional stock trade when I sell some equity to fund a current purchase, or when I buy some equity to fund a future college sized liability. I know in the short term there’s some mania and irrationality to the equity markets, but a more or less efficient market in the medium term means my focus can be on the personal decision about the trade and my objectives, not cash flow or volatility pricing.
Even for traders coming to the options market looking for alternative risk premia, this is good news. I hate to break it to you, but your strategies have been tried before. You’re not the only one that thinks earnings is overpriced or 10 delta puts are always a sale. Don’t worry if the table next to you at Ceres overhears your brilliant idea.
The little bit of edge you might have had in that trade will get squeezed out, but it’s more than compensated for by the increase in liquidity and products available. Cutting down the tax you pay to open and close a position - winner or loser - is significant. In the SPX you might only have to give away 1-2% of your position’s value to close, but fall out of the top 50 names and that number swells to 10-20%. That’s a massive hurdle to overcome.
Inefficient markets obfuscate the matching of risk trade-offs. The other side of the trade is not your competition, nor are my needs and your wants aligned; this is why we trade and have markets. The better we can drive pricing to its ‘true’ value, the better off we all are. It’s the greatest friends and family discount available.