Up in the Cupola
Vol #154: November 9th, 2023
A barn is the apogee of where form meets function. Millions of examples have been constructed across time and place; each suited to the unique individual, location, and purpose served.
While it seems quintessentially American, the broad architectural vernacular is as British as the words I’m using to describe it. English farmers traditionally built smaller barns, and they were constructed using basic framing methods where the walls are assembled, then raised and joined.
Materials were irregular and the barns often lacked a floor, but these buildings met their primary objective- shelter for cows on the warmer southern side and storage for hay on the opposite end. While this plan was initially adapted by settlers in New England, their commercial demands soon required larger infrastructure.
The main hallmark of a New England style barn is that the doors are on the gable end of the building, rather than the sidewall. Balloon and bent framing methods meant these structures could be significantly larger, and serve new and important purposes over the years.
The trains connecting farms to the burgeoning cities of 19th century America meant not only new markets for their products (mostly milk) but also technical innovations like rolling wheels for large sliding doors. As the settlers of the great northeast battled with New England potatoes, they turned these into not just stone walls, but added foundations and floors to their barns. Structures were raised even higher, and basements were added for the storage of either livestock or manure - not both.
Manure as a fertilizer is a method as old as farming. Not only is there an efficient cyclicality about it, the product couldn’t possibly be created any closer to its ultimate destination. This works well all summer, but winter brings two challenges for the dairy farmer.
The first is obviously the cold. Animals need more food the lower the temperatures, and the colonists didn’t buck King George’s taxes just to spend frivolously on feed. Holes in the walls were patched tight so the cattle stayed toasty. Snugly inside, the problem arises of how to handle their main byproduct.
Larger barns allowed for storage underneath, and a trap door helps solve much of the transportation issue. While the smell must have been noxious, the most negative externality was in fact the moisture. “Many large and valuable barns have been very much damaged by being placed over a manure cellar without proper ventilation.” 1
Shafts were thus built extending from the basement straight up through the barn to poke out the roof. The bronzed and majestic rooster perched on the top of a neatly shingled cupola? He’s sitting on a fume pipe for cow shit.
Function isn’t always what it seems. The shiny copper bauble isn’t just a weatherman to tell which way the wind blows, but a critical piece of farm infrastructure that keeps the most valuable players in good health. With as many barns being used for parties as they are planting these days, it’s easy to forget why a bird is perched there in the first place. Farmers are wont to make adjustments as necessary. There’s no development sandbox, he’s cutting holes in the roof on the hot path.
A market maker’s barn is his quoting engine. It is the core tool that manages his inventory and negotiates business. Peeking over a shoulder we see pretty vol surfaces and blinking lights, but like a cupola, the aesthetics of market data are the artifact, not the object of the plumbing.
Every firm comes to the market with a slightly different approach. I can broadly talk with other liquidity providers about the business of edge collection, risk mitigation, and orderflow, but the specific process and tools to aid that are unique to each participant. They are also a closely guarded secret.
While tightly held, the special sauce that one dealer brings to the market may also be completely useless to another player in a different role. This created the opportunity for partnerships, where information sharing could be mutually beneficial with little threat to the core business.
The firm I worked for specialized in lower liquidity issues with highly volatile inputs. There was less volume, but it was a good business tracking that flow and making markets where others wouldn’t. Your vol surface didn’t need five degrees of spline to perfectly model skew, but it was very important that dividends were correct in both amount and timing.
That’s a tedious job to stay on top of - particularly in lower tier issues - but it’s quickly worth it in both avoided losses and captured opportunities. Fees on the other hand, that was something for finance to sort out. Just as anyone knows how to make a cost of carry adjustment, we also knew that fees mattered, but it wasn’t mission critical.
Other firms however lived and died by the fee schedules. We entered into an information sharing agreement with a competitor where they got our dividends and we got access to their updated routing table. This was valuable for both of us because we could focus on our specialties and gain without cannibalizing.
I remember entering their lair one day and it was like peeking behind your secretive neighbor’s barn door. Their quoter was blinking all these fractional pennies that made no sense - those weren’t the markets? But their entire framework was so fee focused, they adjusted every price to be net of the expected fee.
This isn’t just a simple subtraction of a credit and addition of a debit; the fee tables varied by exchange, participant volume, order sequence, and may have had conditions based on the phase of the moon. But it was so critical to their high frequency, near arbitrage-like strategy that the complexity paid off. (Very, very well.)
Rebates and take fees mattered to us at the margin - of course I wait to pay $0.25 vs. $0.85 in fees- but that $0.60 was savings not edge. Getting into an order at the best level, and capturing the most flow in a name mattered so much more. There were hundred dollar bills on the other side of that order.
We spent our energy building tools that allowed for quick and precise manual interaction with the markets, investing in research and news, and developing coordination mechanisms across teams. Edge capture was constantly adapting to the irregularities in increasingly efficient ways.
Wholesalers take yet another approach to the market. Looking at their quoting engine is comparing a Connecticut River tobacco barn to a shingled Maine potato house. Consolidators are also incredibly fee sensitive - they have both customer orders and dealer orders to consider.
While they won’t necessarily ignore arbitrage or curve mispricings, the data engines that drive decisions are calculating price improvement statistics to show off in boardrooms, and break up percentages to gripe about with your exchange rep. The hay is made by warehousing high quality risk in the right proportions for the right price. Business is focused on bringing that risk in the door (steak dinners in Omaha), and managing the inventory (12 monitor admirals).
The specific pump and tilt parameters for a biotech’s SABR model fit are less important than making sure you stay on the wheel and have the risk tolerance and profitability to absorb the inbound customer flow. Of course you have to be able to make money on the trading overall - no small feat - but the metagame is how well you manage the business of trading and orderflow capture.
Just as market makers have evolved specific tools for how they interact with the options markets, so must customers. Their portfolio barn is smaller, but equally purpose built. Selection and sizing of strategies determine how the field will be tilled.
The gentleman’s barn of options strategies is a structured product. It’s a layer of veneer and abstraction on the specific components that appeases and appeals. Defined outcomes without strike definitions.
Simple wrappers in the form of an ETF for options strategies let weekend foliage hunters dabble in the elements without really getting their hands dirty. The good side is they automate something that is rather tedious. QYLD has been selling covered calls for over a decade. It’s up 93% vs. the SPX’s 143% (dividend adjusted). A criticism of automation is that it mercilessly sells upside whether that’s well priced or not.
The other ETF that has my fascination is QQQY. They’ve been selling ATM puts in the NDX index for about 2 months and are just barely ahead of the benchmark. It’s a beautiful demonstration of how much premium is in these, but the devil’s bargain is the lagging on the upside.
As a retail trader truly looking to get their hands dirty, creating a trading process and plan is critical. There is a good risk reward profile to following call or put selling strategy. Iron condors have been working well in 0DTE options recently.
Discipline matters for all of these, but the tools are unique. The reason there is a market is that two sides disagree on price, the only edge in that fact is for dealers. There are lots of good options strategies out there, but yours has the vents, stalls, or hooks that frame your objectives.
“A Model Barn” New England Farmer, April 1852, 272; via “Field Guide to New England Barns and Farm Buildings” by Thomas Durant Visser, 1997.