Thursday, January 28, 2021

If You're Not the Hunter, Are You the Hunted?

I’ve always had a morbid fascination with systemic faults and those that game them. LOR and portfolio insurance. BARRA risk models. Valeant/Shkreli in pharma. SOES bandits, Enron, Worldcom, Madoff, investing in the GSCI as an asset class. Things that seem to be, and ultimately are, too good to be true.

“Market impact” has long been misunderstood by the many. For there is the fiction in the popular mythology deifying the market. This conception imagines financial markets as infinitely diverse where untold numbers of faceless small participants meet to trade in bottomless pools of liquidity (think Eddie Murphy & trading places). In this fantasy, price movements result from a combination of being right or wrong and the thundering herd that moves price towards that efficiency.

Fantasy indeed. The major FX markets are perhaps the closest to this ideal though nation-states still seem to have something to say about that. But most other markets are flawed – either by participant size, information asymmetries, availability and cost of leverage, technical mechanisms of trading and settlement etc. And here they range from the more perfect (think US large cap tech), to the very flawed - like cheese and lumber abused by dominants to manipulate benchmarks for the benefit of cash market extraction. In between, we enter the realm of stock orders where large fund managers may buy a quarter of a stock’s volume on a daily basis for several months running. Such a stock’s resulting relative performance is not random. When Janus Twenty was rocking with inflows, there was no deep market. There was their own purchases moving and pushing the prices of portfolio stocks higher and higher every day (helped by an army of front-runners, specialists, and yes – option specs). While the inflows could stop (and eventually did – and reverse), impact and i'ts positive feedback loop continually drove prices higher. Sure, they could have renamed it Janus 50 and broadened their portfolio, but where’s the fun (or advantage) in that? Janus used their impact to create their own performance and build their business. Today we have ARK in a veritable re-enactment of the Janus folly.

Market impact “strategies” are everywhere. In his heyday, the tall Chicagoan Monroe Trout was known to drop hundreds or 1000+ cars during lunchtime when the markets were notoriously thin in order to trigger stops. TTMC catalogued the impact of size and time across instruments to search for setups where low hanging fruit potentially could be shaken from the tree. This, while clever, was not really kosher. Impact is also the essence for calendar marks that crystallize HF performance fees and move a manager’s fund to the desired quintile in MF performance tables. They are surreptitiously used to skew profitability in principal portfolio trades, MF inflow and outflow prices, momentum and index-related manipulation strategies, for margin and financing benefit, and for setting strikes and expiration values on large derivative contracts (which Luke Ellis can tell you about in great detail). 

Moving closer to the core of my missive, market impact is central to the options market - just as the options market is central to market impact – both in entry and exit. I was present in the mid 80s, to see the first electronic market-maker appear on the floor of the COMEX. It was a touchscreen, adjacent to the gold pit (which incidentally was mis-portrayed for dramatic effect as the Cotton pit in “Trading Places”). The machine, (an IBM PC-AT running Xenix with a early generation Micros CRT touch-screen) driven by a well-coded market-making algo parameterized upstairs, presented floor traders and brokers firm two-way options markets in strikes and months for them to trade against, and would move quotes according to trading activity clocked and underlying prices. Clever as this was, it failed abysmally. Why? Because before a broker would walk into the ring to work a large order, He (and it always was a He), would walk over to the screen and buy some calls or puts for himself (or his brokerage firm’s prop desk) before unleashing his impact upon the market. This adverse selection risk is the same thing that caused Tom Petterfy to get rid of Timber Hill (merging it with Two Sigma) and focus on IBKR. This, and all manner of predatory behaviour related to someone else’s impact, is not without risk. There could be an opposing force of similar or even large size on the other side (such Tiger Mgmt found out when Soros relentlessly took the other side of their end-of-97 Japan high ROE nifty ramp).  Or, exogenuous/idiosyncratic events could make it go in your face (earthquake, pandemic, terrorist attack etc). Even with an information edge, one needs to respect the market and the possibility of the unexpected. 

I’d long ruminated about how – to the largest (mostly momentum) medium-frame marginal buyers/sellers of individual stocks – the options market offered a symbiotic ally, and a potential exit or exit-cost reducer as option market-makers are by definition information-less vol traders. Their negative gamma will accompany and accentuate one’s market impact. Yes, MMs want to avoid adverse selection, but this cuts both ways. For rather than stop making prices if they keep getting carried out by their customer, they can over-hedge, or even go pari-passu (apparently the preferred option in FX trading rooms) in a real life enactment of Mr Burns  “keep your friends close and enemies closer”. Why not profit off of a good thing? 

The curious uncertainty about trading market impact (from POV of one of the anonymous crowd) is that while one can infer the 4-W’s of a move, the only one who can be really sure of the 4-Ws is/are the largest marginal buyers/sellers  responsible for making the market impact in the underlying. And THAT is precisely the asymmetry needed to give confidence to use the options market to one’s gamma advantage. What better information can there be than "I KNOW I am going to be buying 25% of the daily volume relentlessly for the next three months (or six?)? Yes, it helps to have the proverbial wind in your sails if you’re buying. Revisions. Some momentum. Some growth. Not TOO large-cap. There are index angles here too that become self-fulfilling: it’s possible that stocks can be pushed into and out of indices with useful feedback loops. But that’s bonus. 

In my mind’s construction of this strategy, I imagined it would require the utmost careful preparation and research to choose and cycle the best candidates (under-owned, with room to run on long side and over-owned with little short interest on short side). It would require infrastructure both electronic and human – and lots of brokers counterparties (and OTC lines) with multiple PBs to avoid being sniffed and gunned (like GS/Eifuku or LTCM Hillenbrand feared)  (  and the ability to cross and move positions between primes to insure counterparties are always guessing, else the hunter will become the hunted. And lots of capital, because shit happens. And good risk management – for one would want to operate on multiple names without too much bias and have multiple long and short ops in progress. Finally, despite the best laid plans and preparations, it will take balls of steel and private speculative capital with an iron constitution necessary to keep buying and buying something well past the point of divergence or stomach losses when “shit happens”.

Now, if you're looking at me - don't! I’m a pussy - an arb with a modest risk-appetite, and despite having managed sizeable capital in multiple venues with decent results, I never had the mandate nor boasted the psychological make-up to engineer and pursue what long *seemed* possible given market structures and incentives – and increasingly probable given the growing size, concentration, leverage available and mimetic behaviour to the largest and most sophisticated and private participants. Yet no one wrote triumphantly about the possibility. But no one else either told a tale of their blow-up pursuing it. 

In the early noughties, long before Madoff blew up, I advised a large family office who had a decently-sized legacy Madoff position. In the post-mortem (written here I told the story of not being able to ascertain what precisely Madoff did. While my advice to “get out” was correct in hindsight, my best guess of what Madoff might have been doing (relative impact strategies with options) was, in fact, far off the mark. In some ways, I wish they were pursuing something as evil and elegant as that – if only see a real-world validation - a proof of concept.  

Yet the notion that a large operator could acquire sizable lines of stock, then stealthily acquire large low-delta OTM option positions, then buy more stock, unleashing the MM’s short gamma creating a relentless squeeze up, peppered with opportunities to periodically reduce risk at advantageous prices with tactical trades towards expiries was on my mind. Was Rentec’s Medallion using RIEF for this purpose? The wall of money, and size of positions – even in large cap – were of the correct magnitude. The strategy could be hidden in the diversity and turnover of positions without raising alarm. They were the ideal shop – thoughtful, deliberate, quantitative, with infrastructure and savvy - all the tools. Did they ever play around with it? I’ll probably never know...

When the eye-popping moves of this past summer were revealed by the outting of Softbank as the goliath buyer of gamma and subsequent ramper of the stocks, you can imagine my surprise. At first sight, they were the last one’s I’d expect. But shit corporate governance, a bunch of young and fearless yes-boys, and a $100bn of capital in Masa’s Vision Fund can compensate for other shortcomings. Did Masa conceive of it himself? Was it pitched to him by Goldman Sachs? I do wonder what the end-of-trade P&L looks like, or present all-in mark-to-market on rumps of positions.  

Even more unexpected (by yours truly), and ironic given my wrongness about Madoff, was that it would be the rubes of reddit and r/wsb who would figure out the way to game market’s flawed structure, and would be the ones to use the sheer brute tribal force to squeeze, corner and maul the shorts (without seeming undue defection) in a gruesomely perfect market ballet unseen since Volkswagen. Unlike the MAGA losers who stormed the capital, these guys won the battle, and have planted their flag under the Rotunda, effecting a near-perfect squeeze and corner. It is (three days-in at least), a sight of awe and wonderment to behold. For the record, I have little sympathy for the shorts. They played the game poorly. And were intellectually lazy (and cheap) which in all respects made it easier because they too were gaming with OPM.  But make no mistake: this symbolic occupation is a battle victory - not the war. It will be short-lived. Human nature will see to that. And the forces of broader market interest are massing for a siege, such that the 'bros annhilation – whether self-inflicted by over-zealousness or by new extension of the rule of law, will be gruesome. 

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