- Please explain how your job creates value in society.
I don’t generally like to make assumptions, but in my experience people who ask this question generally already have their own idea of the answer, and it rarely synchs with mine but here it goes: My job creates value because we supply liquidity in the markets we trade. Put simply, we post bids (to buy) and offers (to sell) products that are at least 1 cent above/below the best bid/offer. We are like the gas station that offers its gas $.01 below the competition.
- That’s the stock answer, but has anyone quantified the value that gets added in the case that you actually have an edge (information or execution) over the rest of the market? The extreme case is that insider trading adds liquidity too. If algorithmic or high frequency trading were good enough, wouldn’t they have the same negative externalities in that your counterparties would fear being taken advantage of and avoid the market or demand higher yields? The other counterargument is that if you’re not a market maker, then the marginal liquidity you provide is only available when it’s not needed, i.e. when the market is functioning smoothly, and if you know what you’re doing, you’ll be the first to withdraw liquidity in a crisis.
What we do is basically make markets (not as an actual market making firm, but we post bids and offers in everything we trade most of the time). Making markets is different than insider trading in that the information we are making markets off of is public, therefore the liquidity taker can be more confident that there is competition for offering the best bid/offer. A liquidity taker ALWAYS wants a tighter bid/ask and a deeper order book, which is what we provide.
In crisis situations, liquidity is highly demanded, which gives us an even GREATER incentive to post bids/offers IF we can value the security and hedge our exposure. Obviously, the liquidity we post is dependent on liquidity in the markets we use to hedge our positions, but if we weren’t there, the markets would be way less liquid and more volatile. I’ve seen it with symbols I trade – days that I am on vacation and no one is covering for me have a higher bid/ask spread and volatility than days I am in and running our models.
We add value to society the same way that a new supermarket or gas station that comes to your town would add value to society. The same good are available as before, and they are not producing anything, but they are competing to bring it to you at the best price.
- Thoughts on money:
For what its worth, I’ve recently realized that money only has as utility in as much as it can provide some level of security and comfort for you and your loved ones. If you are already at that level, no amount of money will make you feel any happier.
- Do you have any suggestions of resources I can take a look at before I get started?
I recommended a book somewhere else in this thread called Trading and Exchanges: Market Microstructure for Practitioners by Larry Harris. Its an excellent introduction to the field of trading. Additionally, the nuclearphynance and wilmott forums are good sources of information. I would stay away from elitetrader forums though – those people generally don’t know anything about actual trading, only making bets.
- If you were to go into retail day trading, do you think you could make the same amount?
No – generally, commissions, latency are too high, and most of your orders will be routed to a dark pool before they hit the exchange, so you are most likely getting front-run. Our Equities desk (depending on the strategy) makes about from anywhere between .8 and 2.5 cents per share traded. Commission would eat most of that up.
- Writing covered calls – Overrated as a “safe” way to trade options, a good way to make passive income, or just another table at the casino?
I hate covered calls for retail investors, because a lot of retail brokers portray them, as you said, “safe”, but if they were given any kind of education they’d know that it is far from it. A covered call, for those who don’t know, is owning an underlying, lets say MSFT stock, then selling (writing) a call option against it. One of the first things you learn in any financial derivatives class is:
Stock + Put = Call
Therefore, a covered call, using some algebra is the same as a short put. So if the stock increases, you don’t really participate in upside, but if it decreases then you are stuck with all the losses. For someone who knows what they are doing, a sophisticated investor, this strategy can help them save on transaction costs, etc., but for your normal guy who barely knows what an option is, it can screw them over. Another thing to keep in mind is that any time you buy or sell an option you are not only taking a directional view on the underlying, but also a volatility view.
- It seems to me like the structure of the options market is really stacked in favor of market makers. In your experience, how true is this? Or any other insight you can offer on this?
Well, I would say the edge on absolute profitability is on Market Makers & Hedge Funds, but if you think about it, it’s not that uncommon. Market Makers & HF are experts in the products they trade, while hedgers just want their risk to be limited. As a result they go to an expert (Market Maker) to help them, and pay a premium (spread). Keep in mind, if the Client thinks they are getting a bad price, they’ll likely have no reservations on calling up rival firms.
Market Makers can be run over by HFs though, especially in the more illiquid products like Swaptions (Option on Interest Rate Swap). Since price information and true value is hard to determine, HFs can call up a few banks and cross them. It’s not good practice, but it happens.
Market Makers take the spread because they have to manage the risk of taking the other side. There aren’t commissions, so this is the “fee” so to speak of having to deal with positions that sometimes nobody would want to take.
I structured, originated and sold credit derivatives, specifically CDOs, at a top-5 investment bank in Manhattan that ultimately caused massive asset losses in banks, pension funds, and other investment vehicles across the world. AMA
What did you do in your average day? Why aren’t you still in the same position? What changes in thinking and working do you think have happened since the GFC?
I did a lot of analysis and research: I built models to help clients create trades that could make money, such as doing pair trades (shorting one tranche and going long on another tranche, which would make money depending on certain views of correlation skew, etc.). Then we’d meet with the salespeople and help them create pitches to sell their clients on these trade ideas.
We also worked with the deal originators, who would package up a CDO and raise the money from investors to create the instrument in the first place.
Since the crisis, my group has more or less totally disbanded, although they were harder hit than some other groups on the Street. In general, of course, there is much less origination than before, if any. I think eventually CDOs will come back but with a lot more caution and a hell of a lot more skepticism from clients. There will be far more investigation into what exact assets are being packaged into the whole; it will no longer be sufficient to treat it as a hamburger machine.
- So when selling CDOs, did you or those you were buying/trading with have ANY idea what you were actually dealing with?
We did know that the lowest tranches (the “toxic waste” as we referred to it, or more properly the equity tranche), which yielded 20-25% interest, were bombs. So did our clients, which was why we were generally unsuccessful in selling it, except to some hedge funds who thought they knew what they were doing.
Our models showed, however, that the higher rated tranches, typically the AAA rated senior tranches that made up 30-50% of the dollar value of the CDO, were safe instruments. Our error was in assuming that past default rate correlations wouldn’t spike extremely highly. Our clients did not expect that either. Nor did the ratings agencies who rated us (Fitch, Moody’s, S&P).
But these models were not just created to fool the agencies and pension funds into taking AAA rated garbage: we believed wholeheartedly that they deserved the ratings they received. We did know, however, that some of the loan documentation wasn’t terribly good, but there was little we could do to control for that.
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