Game Theory and Market Makers

Market makers provide liquidity to options markets. The buy the offer and they sell the bid. They serve the market to make sure things go smoothly.

Market makers want to remain delta neutral. To do so, they will buy and sell stocks based off the options that they buy and sell.

If a market maker sells a call option, they are negative delta, so they would buy stock to offset it.

If a market maker sells a put option, they are positive delta, so they would sell a stock to offset it.

Opposites are true if they buy said options.

Market makers demand higher premiums when stocks are moving more rapidly. Thus option premiums increase.

Spreads must always be maintained due to the maximum gain/loss cap associated with them.

How does the nature of the market maker and the design of the options contract make it possible to extract maximal profits?

Revisiting Past Predictions

Last week I made a few predictions. How’d they turn out?

I don’t believe the Federal Reserve is going to cut interest rates next week.

Wrong. I believed the Fed would keep rates steady.

I think the Fed didn’t want to disrupt markets which had already priced in a quarter-point cut this month following the Fed’s meeting last month.

The fear of upsetting the markets was there, and the Fed caved in my opinion.

I think the stock market will sell off. I think gold and treasuries will sell off.

Many investors have priced in a rate cut already, and they are preparing themselves for a potential devaluation of the US currency. If the Federal Reserve doesn’t cut rates, those three things will likely be going down.

The market did sell off today following Jerome Powell’s press conference. $SPY was down 1.10%, $GOLD was down 1.31%. However, $TLT was up 1.10%.

In this post, I made a prediction about market volatility:

I think following the Federal Reserve meeting VIX will climb up to 15 or possibly over 17 by the end of the week.

$VIX finished at 16.1 following the Fed meeting today. Fuckin’ nailed that one square on the head.

Predictions for the end of this week

VIX will peak around 23-25.

SPY pulls back to $292 by the end of this week.

IWM pulls back to $151.

I don’t mind putting my predictions out there publicly. It forces me to be accountable and maintain a critical perspective when it comes to my own beliefs.

What do you think will happen by the end of this week?

Why should you expect market volatility to rise in the coming days?

Whenever the Federal Reserve holds a meeting, markets are on edge.

So many investment models must take into account risk-free discount rates, those rates based off Federal Reserve policies. As a result, pricing adjustments always take place around important Federal Reserve meetings.

Investors adjust those models based off what they believe discount rates will be in the future. This month, many investors have priced in a rate cut.

Speculation

If the Federal Reserve doesn’t cut rates I think the market will be disappointed and will sell off.

If the Federal Reserve does cut rates, I think the market will be optimistic (more than they already are), stocks will get a boost, and treasuries and gold will surge.

I don’t believe volatility will stay low this week. VIX is sitting at 13.2 as of now just before market open on July 23rd 2019.

In July, VIX bottomed out around 12.4. It’s bounced off this support line a couple of times this month. It’s surged over 14.5 on a couple of occasions. I think following the Federal Reserve meeting VIX will climb up to 15 or possibly over 17 by the end of the week.

That’s what I think. How about you?

What is the Federal Reserve going to do with interest rates this month?

There’s been much speculation among market participants about what the Federal Reserve will do with interest rates.

Many investors are pricing in the belief that the Federal Reserve is poised to cut interest rates for the first time in over a decade. The speculation hasn’t been about whether there will be a cut, but rather whether the cut is going to be 50 basis points or 25 basis points.

Debacle

James Bullard, President of the Federal Reserve Bank of St. Louis said he would like to cut by 25 basis points at the upcoming meeting.

This came after John Williams, President of the Federal Reserve Bank of New York said the Fed should “take swift action when faced with adverse economic conditions”. This led to much speculation and market positioning that bet on the FED cutting rates by half a point at the end of the month.

A spokesperson had to clear things up for Williams, and stated that he was making an “academic argument”, and NOT talking about the Federal Open Market Committee and their plans for the two-day meeting on July 30th and 31st at the end of this month.

JP

Federal Reserve board chair Jerome Powell has faced harsh criticism from Donald Trump. Trump’s relentless on Twitter about the Federal Reserve and the decision to hike rates in recent years.

He’s been critical of Powell and the Federal Reserve for not cutting rates while central banks across the world are cutting their own interest rates and engaging in other monetary stimulus.

Trump believes that if the Federal Reserve Cuts rates the US will continue to grow and reduce their debt burdens.

Respect

Personally, I believe Jerome Powell has handled the criticism from the President fairly well. I believe he’s done a good job (since December) at communicating the Federal Reserve’s expectations and focus going forward. I don’t know if it’s a popular opinion, but I like Jerome Powell.

He hasn’t caved to Trump, at a time when other individuals have made pathetic attempts trying to appeal to Trump through the media, in an effort to get a position with the Federal Reserve. And I respect that of Powell.

Why Cut?

]Economic numbers have actually been decent in the most recent reporting month. Retail sales rose by 0.4% in June which topped a 0.1% expected gain. On a year-over-year basis, sales increase 3.4%. From a consumer perspective things are still looking pretty good.

What about in job growth?

In June, non-farm payrolls rose 224,000, which was well above market expectations of 165,000. Unemployment rate edged a little bit higher to 3.7%, but is still sitting near 50-year lows. Wage growth was 3.1% year-over-year, one tenth of a point below Market expectations.

Trump continues to tout how great the economy is, but then he wants the Federal Reserve to engage and easy monetary policies which are generally reserved for times where markets are shifting tides.

Trump is trying to toe a line here and all he wants to do is have somebody to blame if the market does go to shit before the next election.

My Predition

I don’t believe the Federal Reserve is going to cut interest rates next week. I think the  stock market will sell off. I think gold and treasuries will sell off.

Many investors have priced in a rate cut already, and they are preparing themselves for a potential devaluation of the US currency. If the Federal Reserve doesn’t cut rates, those three things will likely be going down.

Following all this volatility, the Fed will cut rates by 50 basis points in September. That’s my prediction and I’m going with it. What do you think?

What I’m working on

Lately I’ve been working on creating a report on my trading in my portfolio that I can run using a Jupyter notebook. The code is written in Python.

The purpose of the report is to give me a summary of my portfolio, and how much I have positioned in various stock options. It’s broken down by the different tickers, option types, expiration dates, so on and so forth.

The purpose of the report is to make it easier for me to see where I’m positioned in the market. This allows me to make better decisions I’m sure that I am following those trading rules that I said set forth for myself.

Hedging

One part of hedging is that you need to make sure positions are balanced out in some manner. If the market moves significantly to one side or the other, you want to reduce the significance of the adverse effect on your portfolio. That much is known.

What ratio, type of option, days till expiration of option, and so on and so forth have to be figured out. That’s what I’m working on doing right now. That’s why I created the report. I want to be able to analyze past trades based on the different criteria. I also would like to apply different machine learning techniques to the material down the road. So that’s what I’ve been working on.

When I stopped trying to be right, I became a better trader

I began my journey trading stock options in September of 2018. When I entered the trading arena, market volatility was picking up. This was the environment I traded and adapted to over the three months from October to December of last year, 2018.

During this time period I learned to trade options in an extremely volatile environment. I was able to successfully gain over ten thousand dollars on my small account in December by being short on the market.

I primarily bought put options on bank stocks and other stocks that were experiences drastic declines at the time. My portfolio saw outsized gains which I had experienced up until that point. Enjoying the outsized (mostly unrealized) profits that I reaped up to Christmas Eve, I continued to buy put options on the market.

This turned out to be disastrous.

The subsequent decline

All through January until April, I had the thought that the market shouldn’t be going higher. I absolutely knew what was going to happen next. Or so I thought…

At the time, I was following Fintech Twitter. I wanted to know what was “happening” in the market, and took to Twitter to see what people were saying.

90% of the people on there seem to be bearish during the first quarter of this year. This influenced my investing and my perspective of the market.

The illusion of being a good trader

It took a while, but at some point I realized that being right, or the illusion of being right, doesn’t put money in the bank account.

I called it!

On Twitter it’s easy for people to create the illusion that they called many good trades. It’s easy to do. All you have to do is post a bunch of charts calling bullish or bearish, put them on Twitter, let the market play out, and then delete your tweets that were wrong. Then you can easily pin your tweets where you “called” the market top or Market bottom.

I got caught up in the Twitter atmosphere and my trading suffered. Being right doesn’t matter.

Hedging instead of guessing

In recent weeks I’ve developed better hedges on my trades.

I like to build up large put options positions at times when I believe the market could go down over the next few months.

In the first quarter of this year, I built up put option positions, and lost a significant amount of the value that I put into those positions. It’s only after reflecting and experiencing the pain of those few months then I realize how important it is to hedge my trades.

I was concerned with effectively predicting what was going to happen in the market. I wanted to be right, and I would only enter trades on one side of the mark get out of time. This was stupid. I lost out on a ton of games I could have gotten all throughout January and February and even into March and April.

Current endeavors

I’m currently building up put option positions on SPY and IWM.  I’m hedging the position by buying shorter-dated call options, debit spreads actually, and then collecting profits when the underlying stock price land somewhere in between the two strike prices of my debit spread. This has been a much more effective strategy and has kept my portfolio more even overtime while I continue to build up a larger put option positions.

Ideally, call options on the S&P 500 and the Russell 2000 Index will continue to gain value in excess of the value that I lose on those longer-dated put options while the market continue to rip higher. Then, when the market does turn, I’ll have built up a decent size put option position to benefit from larger price declines.

Conclusion

I believed I had to try to predict the market and be correct. Instead I have to be flexible, I have to adapt, and I have to head to effectively on my positions.

How game theory can help you trade the stock market

I was recently listening to an episode of Shane Parrish’s “The Knowledge Project” podcast featuring Adam Robinson. Adam Robinson is the co-founder of the Princeton Review and he also works as a global macro advisor to some of the world’s largest hedge funds. He’s been  a guest on Tim Ferriss’s podcast, which was how I initially discovered him.

One things I admire about Adam Robinson is that he approaches the world different than most. His contrarian viewpoints on the market have given me a different perspective of how to look at the market.

The traditional investment approaches

In his interview with Shane Parrish, Robinson breaks down the two most popular approaches to investing, and precisely why he doesn’t rely on them.

Fundamental analysis

The first approach is fundamental analysis. Fundamental analysis is the idea that you can analyze a business’s financial statements and competitors, while also taking into consideration macroeconomic conditions including interest rates, production, GDP, and so forth.

Fundamental analysts believe that they can accurately gauge that a company is accurately priced or not. These investors believe that they can determine the true value of a company based off a set of data about the company in about the economy. Adam Robinson states that the fundamental analysis view of investing is that you can figure something out about the world that nobody else has been able to figure out.

Technical analysis

The second popular investment approach is technical analysis. Technical analysis is the idea that you can forecast the direction of prices by understanding the past market prices and volume. Technical analysts believe that you can look at the price chart of an asset along with various technical indicators to understand where that asset’s price has been and where it’s going to go.

If you’ve ever heard about chart patterns such as head and shoulders, double top, double bottom, support, resistance, or indicators such as moving averages, fibonnaci retracements, RSI, MACD, this is how people view the market from a technical analysis perspective.

The biggest issue with technical analysis that Robinson notes is that you can easily trick yourself into thinking some event will take place in the market based off the chart pattern and indicators. The problem is that there’s still randomness that you have to deal with, and just looking at the price action of a security isn’t going to give you the entire picture.

A third approach: game theory

For this reasons, Robinson approaches the market using game theory. If you aren’t familiar, game theory is the process of modeling the strategic interaction between two or more players in some situation where there are specific rules and outcomes to the game.

Robinson’s uses game theory in the market, by waiting for different groups of investors to express their different views of the future. Once those investors express their views of the future (through buying and selling an asset), your job is to figure out which group is right.

You want to pay attention to differences of opinions amongst these groups of investors. You do this by focusing on those opinions which are strongly expressed, and try to figure out which investors are right. Robinson says “I can’t predict the future, but I can tell you what I need to see, to tell you the future is about to change.”

Getting into the minds of traders in the different capital markets

Robinson looks at capital markets from the perspective of those different groups of traders in the markets. In these groups you have stock traders, bond traders, currency traders, Metal traders, and energy traders. Each of these groups of investors express some view of the future through the investments that they make. All of these investors have strong incentives to make money, and take some action (buying or selling) that expresses those views.

Robinson goes on to say that a stock trader who is bullish on the economy (someone who thinks the economy will improve) is going to buy stocks. A bond trader who is bullish on the economy is going to buy corporate bonds and sell treasuries. A metal Trader who is bullish on the economy will buy industrial metals such as copper and iron and will sell precious metal such as gold silver and platinum.

Look for disagreements among different traders

With this perspective in mind, Robinson looks at where there is disagreement among investors. For example, if stock traders and bond traders differ in their views, Robinson states that 99% of the time the bond trader is right.

Sol if a stock trader is bullish on the market in a bond trader is bearish on the market, then you want to be bearish on the market.

Robinson says that of all of these investors, the metal traders are the most far-sighted and accurate group of traders. He says that metal traders have the most simplistic view of the world and they’re in touch with the world economy. The reason metal traders have to be far-sighted is because you have to plan for in advance when you’re extracting metals from the Earth.

Which traders are the most reliable?

With that being said, Robinson ranks the reliability of the various groups of participants in the markets as follows:

  1. Metal traders
  2. Bond traders
  3. Equity traders
  4. Oil traders
  5. Currency traders
  6. Economists
  7. Central bankers

Robinson pokes fun at economists and central bankers and say that they’re always wrong and are out of touch with what is actually going on in the economy. I would agree that the lack of skin in the game (credit Nassim Taleb) is what makes those two groups the least in touch with the market.

You have to anticipate the anticipation of other traders in the market. To quote Adam Robinson again “What I do, is look for these groups to express strongly, different views of the future. Then I express probabilistically, in the past, who tends to be right when these groups disagree.”

This has shifted the way I view markets

Hearing Adam Robinson talk about the market from the game theory perspective completely change the way that I approach the market. While I had been aware of the various markets out there, from commodities to bonds to currencies to stocks, I never knew how these different markets were related or how these different investors approached investing.

Looking at investing from a game theory perspective has opened up my mind and made me more aware of the different attitudes of the different traders in the market. I still have plenty to learn when it comes to these different markets, but this shift in thinking has been immensely helpful to me and I hope it will be a useful to you too.

No China trade deal soon, as expected

trumpxi

As expected a meeting between the United States and China to resolve the trade war won’t be taking in March or April. Instead, the South China Morning Post reported on Friday that a trump-Xi meeting may be pushed back to June.

As I said last week in a blog post, and as I’ve been saying the past few weeks on Twitter, I didn’t believe that we would get a China trade deal. If you read into comments made by representatives by those on the side of the United States and those on the side of the Chinese, it didn’t sound like we were close to resolving some of the key sticking points to getting a deal done.

Listen to the negotiators, not media pundits

In my opinion, if you want an honest assessment of where a trade deal is at, you have to look at what both sides are saying. Don’t listen to media pundits (this means don’t listen to me either). Listen to what the actual negotiators on both sides of the table are saying.

On Thursday a news story broke that’s an official state visit by President Xi Jinping would only happen in the event there is a trade deal with the United States already in place. This fits into with what I mentioned earlier about President Xi maintaining the appearance of strength for China.

I think that the Chinese officials are nervous about what would potentially happen in a meeting between Trump and Xi, especially considering the events that unfolded during Donald Trump’s meeting with Kim Jong-Un in Vietnam.

The Chinese don’t want to be in a position where they don’t have the upper hand. Showing signs of strength are extremely important for their economy and to maintain respect from their citizens.

China is taking desperate economic measures

China is getting desperate. China’s economic growth in 2018 was 6.6%. This was the slowest pace of growth in China in 28 years.

On Friday the Chinese government enacted additional monetary policy measures to try to help support economic growth. Officials even said they would cut “it’s own flesh” to help finance large-scale tax cuts to spur further investing.

This comes even after China rolled out measures in January 2019, such as cutting the bank’s reserve requirement ratio (RRR) to ensure there is liquidity in their financial system. They slashed this ratio by 100 basis points in January, which was the fifth such cut in the past year by China. China’s Banks doled out a record 3.23 trillion yuan in new loans in January, but the stimulus doesn’t seem to be working if they’re looking to slash taxes two months later.

What’s next from here?

The Chinese are doing everything they can to try to maintain a 6% to 6.5% GDP growth rate in 2019. I believe at this stage of the game the United States has the upper hand. However that could quickly change if the stock market comes crashing down. We are all aware that Donald Trump places high importance on the performance of the stock market as that is his barometer of success. And he made this completely transparent when he said a trade deal with China could boost the Dow Jones Industrial Averages as many as 2,000 points.

According to Robert Lighthizer, deal or no deal, trade negotiations will end within the next few weeks. The real question is, are we going to raise tariffs on China if we’re unable to come to an agreement on a deal?

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