Trading Is Like Any Other Business

This post is adapted from this twitter thread.

If you are on the outside looking in at trading, you might think there’s some magic about knowing what a good trade is. In the past week, I’ve explained the same idea to 2 different people so might as well say it here…

In the day-to-day grind of trading options/derivs, all the sharps know the good side of a trade (sports sharps, is this true there as well?) If you could freeze time Zak Morris style and poll them you’d see that quickly. If you ask them why they want to take that side the reasoning will not be because of some opinion or fundamental idea…the logic will simply look like “well party X is bidding Y for Z so if I can buy A for price B and sell Z at Y to X then I’ve got a good trade on”.

So the key to being a sharp is more of seeing flow and knowing where the real bids and offers are. It’s knowing where the buyer’s bid is, and if they have more behind, or if they are in-between reloads and so on. It’s not based on some super-secret model. All the sharps wanna do the same thing which tells you opinions of what is cheap and expensive are table stakes. And if they disagree…congrats, you’ve found fair value by definition. The pick’em price you can buy or sell at.

The market tells you immediately if your trade is a good or bad one. It offers in your face after you just bought (bad trade). Or it fades when you try to lift and ticks you (good trade). I remember in trading class one of the partners explained that the definition of a good trade was one that is bid where you just bought. The worst-case scenario is you just scratch your trade if you want.If your trade is bad it’s because don’t know about something else out there. You are being quasi-barbed. You are actually providing liquidity via an intermediary to something else you don’t see!

The role of a market-maker, and why it’s a business and not speculation makes sense. They are the intermediaries who bridge the liquidity between actors who don’t see the whole picture because they are narrowly focused on their own knitting. For the market maker to be effective, they of course have to have the table-stakes sense of what’s cheap and expensive on a relative basis.

But the main job is access.

They need to see the flow.

Every limit order out there is an option for them to lean on. If there were no orders, no flow, no need for immediacy by a natural investor, then the cloud of prices would be quoted around some generic model. It would look orderly. Things get out of line because of flow. The info in that flow causes market-makers to Bayesian update fair value.

Brokers bring flow to market. It’s a competitive biz. If JPM gets their cust a bad fill, next time the client will use GS. So a market maker has a homeostatic relationship with the broker. You need to be tight enough to win the broker’s flow so they don’t get embarrassed (if I sell you something at $5 and it’s immediately offered at $4.90 the broker is gonna be pissed), but not so tight that there’s no margin in the trade for you.

There are many traders willing to provide prices to brokers. The brokers own the relationships, the flow, the lifeblood of the business. The resulting dynamic has parallels to other businesses in terms of economies of scale. For example, I might need to put up the brokers at fair value in liquid ETF options so that someone else on my team can win the more lucrative single stock flow. In a classic sense, I’m a loss leader.

I traded commodity options. This is an intensely competitive options business because banks are willing to provide large physical clients attractive option prices because there’s lending/banking business they can win from them. Being a market maker in a market where some party has effectively “commoditized the complement” is a tough place to be when your business is only in trading the “complement”. In a broad sense, the bank is seeing more flow than you. If you insist on competing with that you need to be aware and lean into your competitive advantages over the bank. Maybe the bank desks are silo’d along another dimension where you aren’t. That can be a wedge for you to compete.

In sum, trading is just one of many types of businesses and has many parallels.

It’s not some magic crystal-balling. The models are not the edge. It’s the combo of doing many things well. Technology, relationships, organizational behavior (just think of the alignment issue where one desk is a loss leader for another…how does comp work in such a situation? Who gets what seat? What skill is more scarce? Chickens/egg problems abound).