Twinkle Twinkle

Vol #203: November 14th, 2024

Many pages back in my Amazon order history I purchased eight reams of multi-purpose copy paper.

8.5” x 11”, 20 lb, 92 brightness. It took months before I made a dent in the first pack of 500. There’s not a lot of stuff that gets printed here. It’s nice to read the hard copy of a contract or a white paper, but a few dozen pages of that would be a very busy week. 

Where the paper gets used here, is for drawing. Sometimes by me planning the next over engineered home improvement project, but more often by my daughter practicing a new word, style, or shape. Lots of rainbows. 

Our current challenge is drawing the perfect star. The five pointed style that asterisks a hand written note, or glows up a leaflet. I must have been at least double her age before I could do that. But I was today years old when I learned that this style rose to prominence when the flag of the United States was introduced in 1777. Five pointed stars were rare in antiquity. 

Grown ups make short, quick lines, and dash a twinkling accent with their unique handwriting. Not as easy as it looks and the learning frustration is palpable. She knows what the ideal star looks like, but cajoling fast growing hands into muscle memory lane takes some time. 

There is a geometrically correct answer here. The model star has perfectly balanced legs and angles - an equilateral concave decagon. Artistically improved solutions include swooping lines and elongated features to add just the right amount of kindergarten teacher flourish. 

It takes many repetitions before you can start playing with the features. The novice must be obsessed with perfect imitation of the model. Rote practice of trying to echo the Platonic ideal in our physical world. 

The imitation business doesn’t end with tracing paper. Whether it's the three part essay or a new play on the field, following the plan is an important part of learning. It’s also critical for understanding, and how we view the landscape of interactions. 

In trading and investment management, the word “model” shows up regularly. Model portfolios are built, tracked, and rebalanced. They become benchmarks, creating an ironic twist of fate where creativity is risky and fidelity to the average is the superior business practice. True alpha is too expensive for most. 

Experienced practitioners will tell you that the map is not the territory. All it takes is a globe and a Mercator projection to realize this. Greenland and Antarctica are stretched in funny ways when you put them on a sheet. It’s fortunate this can be proved objectively, because it helps validate the situations where even if we could carry a globe on the trek, it wouldn’t be perfectly useful.

Besides telling us where to balance our 60s and 40s, a model can also be a useful way to contextualize the behavior of market participants. At the very least frame the boundaries where risk is taken and capital is allocated. 

In markets, predictability is an Achilles heel. A model cannot precisely define interactions, because if someone knows what your next move is, the price will be higher. Whether it’s by constraint or naivete, a counterparty whose actions are known will pay more for both liquidity and securities. 

Different players act mechanically, according to the model, for different reasons. Mandates about exposure and rebalancing drive predictable flows. When TSLA gets added to the S&P 500, there are a lot of mimetic vehicles that need to buy the stock. 

Market makers seem to act somewhat mechanically also. Grocery stores and gas stations follow simple rules to add a bit of margin to their cost of goods sold, and as the price of strawberries and petrol moves, so does the cost to the consumer. Dealers are simply adjusting the price of liquidity. More buyers than sellers is almost always the answer. 

There have been many attempts to define the model that liquidity providers follow. The order book is built from both price and size, and with these two levers participants come together to express a collective view about value. 

Going back as far as the early 1980s, the Ho and Stoll Model formulated that inventory was the key driver of dealer price adjustments. When there are more buyers, dealers get short, and they need to adjust their bid-ask spread to account for changing positions. 

In addition to the risks of building a one sided position, there is quite a bit of information asymmetry that dealers must price. Later models account for this in different ways, and assume price and spread adjustments based on the relative mix of informed traders and risks of adverse selection. 

There is even some consideration about how the dynamics of orderflow work. Dust off your Poisson distributions - how many different SPX orders do you think will come in the next X minutes assuming there are Y per day. A lot of orders means there’s a good chance of an offset, so dealers can provide better liquidity. Volume keeps the quotes fresh, up and down the logistics chain of market plumbers.

This trickles downstream to the latest attempts at modeling dealer behavior. If a dealer can buy a call and flip their inventory - or at least significantly neutralize the risk with a like option -  there’s no need to touch the underlying market. But if positions change or orderflow is imbalanced, risk management best practices will necessitate more aggressive hedging. 

How all these factors play out in reality is far from rigid or predictable. The logic is not wrong. Inventory management, adverse selection, participant analysis, and hedging are all core to the business of liquidity provision. 

If you simply download the Avellenada-Stokoiv plug in on python, and start streaming quotes in crypto markets, the perfect setting of a reservation price won’t translate into PnL. Counting up all the greeks in the market doesn’t tell you which way the SPX moves at 2:15pm. 

What turns any model into a real trading strategy, is finding just the right way to bend the star beams to match the situation. Simple equity investing strategies can hug the model and outperform most asset classes. But to justify the active participation in markets - trading - you need to go beyond that. Edge isn’t following the delta hedging prescription on your terminal, it’s shaving pennies off your execution by finding less impactful ways to do that. 

The five pointed star on the American flag is iconic. The perfect sticker for a top notch essay, and the template to practice on as we learn the way to shape points together. But it’s far from unique. 

You need a special flourish of handwriting to turn a model into money. That’s what the next ream of paper is for.