You Can Do Magic
Vol #146: September 14th, 2023
“Fire up the gardener.”
The melodrama of trading pit cloak and dagger is pretty goofy. We didn’t want the frenemies we bumped monitors with knowing we had an automatic hedging tool, so we called it the gardener. How clever.
Obviously it was pretty quickly known across the floor that we too had a way to sell stock as soon as an electronic trade hit our machines. Matching engines spit out drop copy reports that were wired up to your badge and had latency measured in milliseconds. The picosecond delays today are a billion times faster. A billion times greater than 5 milliseconds is 57 days.
That paleolithic communication didn’t matter because equities also moved slower. The “Smart” router that our executing broker used was directly integrated into our software and we blindly fired orders two cents through whatever the last bid or offer was that came over the wire. Transaction fees were 10x what they became 5 years later.
This quick two step put us a few ticks ahead of the competition. Our biggest upstream competitor already had something like the gardener, but there was plenty of fat left over for the consistent second place.
In normal markets this worked pretty well. Trade. Hedge. Fade. I could write a script to do that. Things would get gummed up when fast markets happened, and the flood of data dumped on everyone like that mythical box of upticks. Log files had multi second gaps, and you could fill in the blanks with a vertical stock chart and all of the quote updates you woulda, coulda, shoulda sent.
Pick-offs kept everyone on their toes. Options markets moved faster because stocks were moving faster. Spreads tightened and commissions got slashed as the technology arms race surged. In 2000 you could be a sole prop with $100k and reasonably participate. By the 2010s it was estimated that building a competitive options market maker from scratch was a $100M endeavor.
All of this was on the backs of software.
Development teams in every corner of the ecosystem ballooned with the highest caliber professionals. Trading firms reorganized themselves from managing an army of sheet running clerks to a brigade of fiercely intellectual engineers. Anyone that wanted to win business had to keep up.
Brokers, exchanges and prop shops were all figuring out how this worked together. Off the shelf software was cobbled together with home grown APIs. With this Cambrian bedlam came a lot of structural limitations.
“Can the widget do this?” was often met with a technical explanation about why the functionality was limited. The groans deepened when you heard about the queue for support tickets.
As things matured, the constraints were no longer technical, but resource related. There were only so many development dollars and CPU cycles, but beyond that were fairly green fields. The answer about what the widget could do quickly became a platitude - “You can do anything with software.”
While technical debt and embedded design decisions may dramatically increase the cost of achieving some project, the saying is true. You can do magic.
Given an ability to do anything, the typical operational challenge is turned on its head. We must ask ourselves what to do, not how to do it.
We’re confronted with this problem of what to do in other unique situations. Flip through Zillow Gone Wild and you’ll quickly find a construction project that reminds you that just because you can, doesn’t mean you should. A carpenter can also do anything, so be careful what you wish for.
What kind of porch to put on the front of your house is a question of taste. Architecturally there might be a more or less correct answer, but tack a rotunda on that colonial if you want.
What software to build is mostly a business question for market participants. Which functionality brings in more customers or makes me more money. Or helps me avoid fines. It takes a small envelope to calculate the cost savings from wiring in a new broker connection compared to the number of man hours it takes to build that.
For buy side users of options, ‘what’ to do with options is somewhere between a question of taste and pure economics. There are some fairly consistent truths and best practices, but it mostly depends on what you’re looking for.
Some buy side users are trading options as a business model. There is absolutely edge out there for even retail traders to capture - it’s tough though. There’s also edge for the top tier market neutral pod shop delivering pure alpha.
Excepting the giga-brains and grit masters, options have good use cases for everyday investors. The what to do question is about alignment of risk tolerances, expectations, and most importantly trade offs. You’re only getting paid on a covered call because you gave something away.
Leverage is an obvious use case. It’s also wildly dangerous, so proceed with extreme caution or most likely not at all. Well managed though, taking on a bit of additional risk via leverage can allow you to be both capital efficient and capture additional premiums.
If you want to take on a bullish position in a stock, using a poor man’s covered call (long ITM call, short OTM call) gives you a levered position that looks mostly like a stock overwrite, but with a much higher bar than a $0 stock price where you lose everything you invested. Getting a little spicier, I like the risk reversal capture where short puts and long calls can be managed as a synthetic delta position. Combine this with regular equity holdings and you can extract additional premium - by taking additional skew risk.
When you use leverage, what you’re looking for has to be additional risk as well as additional returns. If you don’t want, can’t stomach or afford the downside, walk away now.
Protection is the other obvious direction to take an options strategy. There are many cases where protecting capital is worth paying for. The beauty of options is you can choose from several different payment methods. Sell a call to finance puts, or pay for half out of pocket. Overwrite the entire position and cover half the downside. Sell the 25 delta call versus buying the 15 delta put, raise the temperature but skim the difference.
All of these have slightly different tradeoffs. Some traders like the feeling of collecting premium, others are more comfortable with debit only strategies. Combine short calls with put spreads, or break the wings of your butterfly to get a skewed payoff.
Trading options across different expirations layers in another dimension of exposure. Dancing across duration risk with active rolling can produce excess returns, but also has higher transaction costs and more nuanced trade-offs.
Finally, options have a use case in that they are fun. There was an article in the Wall Street Journal earlier this week comparing how retail users are playing 0DTE options with gambling. There are numerous quotes from traders relating their experience to poker, and how they regularly lost 5 figure sums.
While I certainly don’t advocate framing your brokerage account like a casino, the way these users were all describing their experiences fits well into my belief in the “play account.” If you haven’t bought a call with hours on the clock and watch it melt or rocket, do you know what you’re missing?
With all the games of chance available out there, the major difference is that options actually have real use strategies you learn about when you play with them. Knowing how theta acts on that one day call graduates into managing your roll timing on a buffer protection strategy.
Any of these different scenarios can produce magic for you. Not in the sense that returns will burst from a wand, but that they will be the appropriate wrapper for your objective. When you cast your spell and get your way, choose carefully.