Today I’m going to both be a student and speaker at Ricki Heicklen’s Quantitative Bootcamp in Berkeley. Ricki is a Jane Street alum who got on my radar when I heard her interview with Patrick Mackenzie.
I summarized the convo in A Jane Street Alum Teaches Trading but it’s still a long article. The interview is dense with insight. Very rare for this stuff to be presented in such an accessible way in public.
Early in the interview Patrick asks Ricki to complete this sentence:
“I’m going to impart a bit of information upon you to get you ready for understanding the US equities markets…” – if you only had one sentence, what is that?
Ricki, without hesitation:
The number one sentence for purposes of trading, in general, is to think about adverse selection.
The questionnaire she give to incoming students is loaded with tricky examples of adverse selection hiding in seemingly innocuous scenarios. You can get some flavor of this in her post Toward a Broader Conception of Adverse Selection.
💡Aside: Polling has been a popular topic recently for obvious reasons. Adverse selection is a sibling of sampling bias. It’s the mother of monkeywrenches in statistics. This back and forth between Ben Orlin and Jim O’Shaughnessy has several fun, yet profound, examples of sampling bias.
Mathematician Ben Orlin on Infinite Loops podcast audio & transcript (6 min)
Fellow Jane Street alum, Agustin Lebron, has also emphasized the significance of adverse selection. In his exceptional book, Law of Trading (my notes), chapter 1 is about motivation. Chapter 2 is, you guessed it, Adverse Selection.
[The obsession here is not misplaced. SIG or any other market maker is going to dwell on this because markets are not kindergarten — your counterparty wants to make money by disagreeing with you so understanding if they are safe to trade against is the a primary objective.]
The chapter includes several great examples of adverse selection in financial markets, but as every chapter does, it closes with practical applications that are pertinent to anyone not just traders. I’ll use this extended excerpt about adverse selection in the labor market to setup today’s discussion (emphasis mine):
Adverse selection in the job market appears on the side of both the employer and the prospective employee. Employees are looking for the most attractive job they can find, while employers are looking for the best candidate for the job.
Prospective employees are subject to various selection pressures, not all of them adverse:Given that the company is looking to hire employees, things can’t be going all that badly for the firm. This could have a positive selection effect, for once. Nevertheless, maybe the company is hiring because people are leaving and they’re having trouble finding hires. It’s a double-edged sword.The job description is likely to be embellished, at least a little bit, especially for less-attractive jobs.The interviewers in a company are typically better-than-average employees since they’re the ones the company chooses to represent them to potential hires. Thus, the applicant sees a rosy picture of the quality of her future co-workers.Employees typically only seek out new jobs every few years or so. As a result, their skill at job finding is lower than the companies’ skill at candidate finding. This asymmetry of skill and knowledge works in the companies’ favor.
Employers, however, suffer significantly greater adverse selection, since in the end the employee is the one making the final decision of either accepting or rejecting a job offer [Kris: the candidate holds the last option — it’s like the asymmetry in backgammon with the doubling cube — you must have significant edge to offer it, but you only need to have a 25% chance of winning to accept it. Btw, this was an interview question I had back in 1999]When hiring people with prior experience, the applicant pool skews in the direction of lower-quality workers. This is because good workers will be preferentially incentivized to remain with their current employers. On average, therefore, people with prior experience looking for jobs aren’t as good as those who have jobs (Greenwald, 1986).The process of interviewing to decide whom to hire is an imperfect one. Companies will therefore not be able to sufficiently distinguish between good and bad workers, meaning they will tend to squeeze offered wages toward the average. This is advantageous for less competent workers, who, for the most part, will be the ones looking for work, and disadvantageous for good workers, who will be driven away from the job market by the lower-than-deserved wages on offer. [Kris: this is the so-called “lemon problem” in the used car market]Potential employees will select the best offer from all the ones available to them. Good workers will have a large pool of available offers and will pick the best one. If a given employer isn’t universally known as the most desirable one, then it’s fair to say that a worker who accepts an employer’s job offer does so because she couldn’t get a better one elsewhere.
A reasonable blanket assumption is the employer faces a larger adverse selection problem than the candidate.
But what I want to talk about is how with experienced option traders I have seen this flipped. Well, maybe not flipped, that’s hard to say but I can pinpoint a somewhat narrow but substantial area of adverse selection that I’d expect was more prominent in the past 5 years.
Whenever I have a call with a trader evaluating an opportunity I warn them about this because I’ve seen it time and time again.
No math or charts today. This is a topic for experienced professional option traders although I’d bet it could be generalized faithfully to anyone with valuable experience who is being sought after. You can make the adjustments for your own field.
I’m going to be very direct since you are not a learner or novice. If you’re at this point you understand the angles. You are already damn good at what you do. The failure mode here has nothing to do with your competence as an option trader or risk taker.
The failure is one of expectations.
I’ll lead with a blunt warning:
Beware asset managers trying to “get into options”
The entire options ecosystem has exploded in the past 2 decades. Pick your buzzphrase:
“VIX complex”
“Tail hedging”
“Iron condor”
“Covered Calls” (I’m old enough to remember these being called buy-writes)
“Dispersion”
“Hedged equity”
“zero DTE”
Even the word “optionality” metastasizing from finance to VC (that verb was pointedly chosen but also to be fair stock-based comp and option grants are good reasons for tech workers to get nerdsniped by option lingo).
Netflix has a film about a human named RoaringKitty trading options on a brokerage called Robinhood.
The growing awareness of options is self-evident. (I like to think moontower has a sprinkle of guilt in the matter.)
Since asset management is as much about sales as it is about alpha, you can see how the democratization of option knowledge has served as a fortuitous “commoditize the complement” strategy for opportunists who think in terms of “product” not edge.
Simultaneously, (and I’m going to paint with wide brush), a class of crypto moguls blessed with more nerve than trading acumen, have coffers from which they can punt on new businesses.
If you are a successful option trader looking to build a business or graduate to a more senior situation, this backdrop is a godsend. You have experience that is:
a) highly complementary or non-overlapping to the people who covet it
b) the demand is coming from businesses that are sitting on lots of capital given where markets are broadly
In other words, there’s a lot of money out there that wants YOU. And since anyone whose ever fantasized about flipping the desk in their bonus meeting after getting a 5 out of 5 on their performance review but the cash is your “median expected bonus” knows — haggling over pay with other option traders is Gold medal round of the gaslight Olympics. And I say this during an election week.
The contrast of being woo’d by rich business people who don’t really understand YOUR business is a welcome (and foreign) asymmetry.
Unfortunately this attractive setup is also the danger.
I’ll pose this question and I hope I get some responses…do you know of any firm that did not deeply understand options that successfully got into vol trading by hiring an option trader to build the business?
I’ve seen option traders launch funds from scratch. I’ve seen option traders join pods or move from one trading firm to another. Banks have revolving doors for traders.
But when I think of instances where an established asset manager tried to “get into options”, none have lasted.
my theory
Non-option managers do not understand (nor desire) the true shape of a vol trading p/l.
Here’s a few flavors of disappointment:
- They expect steady profits only to discover that only the market-makers operating at scale make money every day. That’s not a reasonable expectation.
- They expect to make money when the market gets stressed only to discover that dispersion gets hammered on the first leg down. Of course, experienced option firms know this and even embrace the pain on the token short corr position because the real opportunity is coming and your going to make the real money when the environment relaxes. Of course, that p/l stream will look correlated with the asset manager’s core business so that’s disappointing.
- Build an option business with a long vol/gamma/tail bias. Lose patience or faith in what that anti-correlated stream does to your business holistically. Focus on the line-item drag that this new business is. Nudge the option trader you hired to increase the batting average and get disappointed when you find out that swinging for contact means sacrificing power.
red flags
If you are being recruited to build an option business for a firm that is not native to options, here are some red flags:
- Not understanding the shape of dispersion p/l
- Wants to impose risk rules that do not make sense in options. Stop-losses do not make sense in options. You want to constrain your risk a priori so that it’s survivable (however defined) not have a risk rule that has memory since the best opportunities in vol (a domain that has mean reversion) are seeded by pain.
- Doesn’t realize how expensive/laborious it is to build proper risk monitoring infrastructure, security master, and back office ops. If you are building a significant option business from scratch and they expect p/l in year one, they are either delusional or willing to throw a ton of money at the build-out to make it go faster. The comp deal they offer you should be a big clue (I say this not just from personal experience but by helping other senior traders weight their offers — I’ve helped at least 5 people with this in the past year alone. There is a wide canyon between a serious firm’s deal and a “I heard there’s money in options” firm.)
considerations on more promising sources of expansion
While I’m generally bearish on the prospect of a happy marriage between asset-management suitors and option traders, I’m more optimistic on non-option prop firms expanding into options.
For example, HFT firms are in capacity-constrained businesses. But they are cash-rich, smart and have economies of scale and synergies with other public market strategies. They are more natural fits for high volume option traders.
Caution is still advised.
A few ideas for candidates to keep in mind:
- HFT firms are not in the business of warehousing risk. They are flippers. Option trading is a lower Sharpe (should still be north of 1 and with attractive anti-correlation and perhaps even tail properties). What’s the suitor’s commitment to something that will expand their capacity but slide down the risk/reward continuum? Sitting next to an HFT’s equity curve is gonna make an option trader look flabby. Again, what are the expectations?
- Single stock option traders pay attention. You know as well as anyone that the requirements and nature of trading single name vol are vastly different than index, commodity, fixed income, fx or other liquid markets. Especially in options. The barriers to entry in the liquid markets are lower so firms that survive their inception and move on to expansion will typically have started in index or futures markets. Which means they don’t know what they don’t know when it comes to single-name. Don’t presume their understanding just because they are smart and successful up until this point.
closing words
Candidates, you’re in a mixed position. You are already successful. But you are coming into another part of your career where it’s not just about trading but building. There might be lots of details of your business thus far that have been abstracted or handled for you. Things that are not market-related that you don’t enjoy thinking about.
Now you need to be the one with all the answers. You will need to delegate, project-manage, and communicate to stakeholders who might not speak your compressed dirty trading language.
You will also face what I call the “realtor problem”. An honest realtor is forced to compete with the hooker who shouts the highest price to secure the listing — “you have the most unique house on the block, I’ll get you 20% more than neighbor got”. There will be candidates that pump up the suitor’s expectations and minimize what’s required. It’s hard to compete with that, especially since they will sound far slicker than the sleazy realtor. This is the big-leagues.
Matching to a mutually rewarding relationship can take a long time. Anecdotally, between garden leaves and the innate specificity of roles, you can easily expect a full search to take up to 2 years and even once you are in process, 6 months to hammer out details is not abnormal.
It’s incredibly expensive to let hope overwhelm logic.
Cold feet is one thing, but don’t ignore nagging feelings. If it feels overly provisionary, opportunist, or like the suitor is trying to time something you should be on high alert. A quality connection exudes patience, long-termism, and ambition — you don’t move needles by thinking small. And you don’t hire people who can deliver on ambition by playing games with them.
I’ve definitely seen deals stand out as “how a serious employer treats a quality candidate”. Deals with experienced traders will often allow the candidate to tune their utility curve by trading off between guarantees, percent of profits, base and so on. This makes sense. Firms are in a better position to absorb the risk of the relationship than the individual so so they can allow some latitude for the candidate to choose across some indifference frontier. This costs the firm nothing, but increases their chances of landing the candidate.
[One word of caution: anytime you are negotiating your share of the profits you are implicitly negotiating the amount of risk you can take. Getting a high payout on a deal where the boss asks why you lost $10k today is probably not what you had in mind when you agreed to the job. Expectations here are everything. Be explicit. On a similar note, if you are on a high payout deal but it takes 6 months to get your accounts set-up is garden leave without the view. At the end of the day, bargaining position is everything. I wrote this post 5 years ago and don’t link to it enough — You Better Understand The Difference Between Contracts and Power]
If you are in a position to help grow a business, the most important decisions is not a strategy or trade — it’s the WHO. Do not grant the benefit of the doubt easily. There’s too much time at stake.
I’m harping on all this out because I have repeatedly found that the superficial similarity between options trading and other investing businesses is strong. But this masks the inevitable moment when the business owner sees a a bad run and realizes the contour of this new business is not what they bargained for.
At this point, everyone has wasted a lot of time and money.
The single biggest problem in communication is the illusion that it has taken place — George Bernard Shaw
A short take on my own experience
I was fortunate in my career to work for people that were consummately patient and respectful. In other words, they didn’t make the inevitable bad runs worse. They understood the shape of option trading. They understood what it means to “not result”. They offered perspectives but ultimately it was up to me on how to maneuver. I was allowed the space to work out of my slumps on my own. Patience is never endless but I never even saw the hint of where it was starting to deplete. (If anything, and I’ve talked about this before, my struggle was in being less cautious. They trusted my instincts more than I did.)
Final Postscript
Here’s an excerpt that you can choose to weigh in your assessment of a suitor’s incentives, obligations, pressures and how they’ll be as bosses.
It’s SIG director Todd Simkin explaining the value of being a private investment company without outside investors on the Capital Allocators podcast (link):
We’ve been in a really nice position of having the most patient capital of all. One of the problems with hedge funds is that they have to frequently manage to not just quarterly reports but monthly reports or even weekly and daily reports. So they’ve got to show that they’re staying with the strategy they have outlined for their investors and that they’re showing regular returns.
Our investors are the principals of the firm. They understand the risk. When we take outsized risks, they understand what they are. They’re the ones who are driving it. If I want to put on a $100 million insurance risk where the full exposure is to the winner of the Super Bowl. I’m not worried that if we lose on that risk that I’ve got to now explain to a whole bunch of people why we just lost their money. Instead, I’m calling one person and saying, hey, are you okay with me taking this risk? Here’s the edge I think I have. Here’s the rate at which I can sell it. And he says, yeah, that sounds good. And he’s monitoring it and he’s asking about it and he’s checking on the health of the quarterback through the season, all the things that you think would happen when you have that type of risk on.
But because we’ve been able to be patient, we’ve been able to stay in businesses and grow businesses that have had downturns. And at the same time, we’ve been able to shut down exposures where other people would say, sorry, we have to have our long short equity exposure because that’s what we do. That’s the business we’re in. That’s what we’ve told our clients we’re going to be doing for them. So even though that’s not the strategy that’s optimal right now, we still have to allocate whatever percentage of our portfolio to that. We get to shift dynamically. We get all of the benefits of having a large capital base with all of the benefits of having a small number of decision makers at the top who are weighing in. They’re not putting artificial rules in place that we might have seen if we had ever taken outside money.
Stay groovy
☮️