>having been shown, empirically, to work.
What exactly do you mean by this? That they are correct most of the time? Or that the person that uses them won't go bust?
This parallel between physical theories and assumptions about how the market works is bogus. In trading you can have strategies that are correct most of the time yet when they fail the impact of the loss can take you out.
Yup. Options market makers, the critical mass of dynamic hedgers, don’t blow up any more [1]. I left the business ten years ago, and was probably among the last well-paid people to do it. There isn’t much risk anymore which means there isn’t room for ingenuity—it’s execution, mechanical.
Between market circuit breakers limiting instantaneous price moves; the tremendous amount of liquidity in option-covered symbols; tail-risk estimating options models; and fully electronic options, equities and money markets, there simply isn’t empirical evidence for hidden risks in the model. Cash equities execution was once super complicated. It’s now commoditised. Same for options.
It sells books to claim otherwise. But you largely need to re-tell stories from the 90s, where LTCM bet on short-term Russian debt, or recount crisis-era structured products on illiquid mortgages to fill the pages.
[1] American OCC-cleared options market makers who aren’t making directional bets but manufacturing options and hedging their books
I wonder if that's true in insanely volatile stocks like GME? People were buying way OTM calls on that stock. Then the stock would move 50% in one day. A market maker would have to be very good at dynamic hedging to keep up with that.
Of course options market makers have one incredible thing going for them. While they have market risk for every individual option they write, their net exposure can potentially be very small. That only works for a market maker, not for someone making a directional bet because YOLO.
Edit: The few times I tried to study what was going on with GME options, I saw a lot of "no bid" on many OTM strikes. So it looks like the market makers were simply stepping away. Which totally changes the market dynamics. If there's no liquidity in an option, a punter's only choice is to hold to expiration? That's financially very risky and also counter to everything we've come to believe about an "efficient" market.
Bingo. Self help [1] and circuit breakers [2] negate the unsolvable edge case: large, instantaneous price movements.
[1] https://www.reuters.com/article/usa-options-cboe-idUSL2N1H40...
[2] https://www.npr.org/2020/03/09/813682567/how-stock-market-ci...
> There isn’t much risk anymore which means there isn’t room for ingenuity—it’s execution, mechanical
What do you mean by ingenuity here? Like coming up with your own model that was better than other people's models, or new strategies, etc?
Also, what the heck is an "aerospace investment banker"? Someone in IB who only works on aerospace stuff?
Creativity. What you said. No more 10x improvement opportunities. Just marginal adjustments. Maintenance. Running the same model a bit more efficiently, carving off minuscule edge cases here and there.
> what the heck is an "aerospace investment banker"
A made-up moniker. I raised money—and did deals, e.g. IP licensing, M&A, PPP, et cetera—for rocket, satellite, drone and adjacent start-ups before that was a thing. I had enough technical knowledge to know we were and are on a precipice. Computer-aided design, singularly, as well as new fluid dynamics numerical methods being unsung and recent game changers; falling launch costs our transcontinental railroad. But not enough to do the work myself. So I sold and structured, things I am good at, while reading Banks and Nivens and K.S. Robinson on the weekends.
Really rewarding work. Didn’t pay that much, unfortunately, though the resulting equity changed my life.
No creativity makes it sound like the market has been figured out. I know that isn't true, so does that mean that the risk/reward of strategies has flattened off (I.e. same risk for less reward) because there are less opportunities to exploit?
> No creativity makes it sound like the market has been figured out
That was my bet. It has, so far, been a good one.
> does that mean that the risk/reward of strategies has flattened off (I.e. same risk for less reward) because there are less opportunities to exploit?
Your instinct was on point. You don’t need someone with a feel for volatility to make money (or not lose it) in options market making anymore. The work consists of, and will for some time, re-implementing existing ideas. There are still mis-pricings. But they aren’t inherent to the pricing model. The commodity component can be isolated and run with an eye towards costs and economies of scale.
(This has been a fun conversation, by the way. Thank you.)
In the same way a rocket flight model is forecasting the arrangement of air molecules it’s about to run into. They’re instantaneous forecasts that are dynamically updated. No long-term forecasting involved.
At the end of the day, options market makers haven’t blown up since the early noughties. (LTCM got sunk by non-options bets.) They are low-margin, low-risk businesses. It’s fun to talk about them like they’re black boxes. And traders trying to defend their compensation will keep pitching them that way to senior management. But options pricing is a boring, largely solved—if still interesting—problem.
Since the model to convert parameters to prices and quantities would be known in advance to all traders, the next step could be providing a feed of current parameters which traders could use to build their own view of the public book. They'd still need plenty of quotes published piecemeal as now (as not all quotes would be model-generated) but the messaging could be much more efficient, and that could lead to more options trading.
No market works like this. The smaller-still message of a price is sent and disseminated. When you buy a flight, you want the price of the ticket—not the airline’s fuel and tariff costs.
Btw when interest rates went negative for the first time, many trading shops were caught pants down, because of course their models did not have a provision for negative interest rates.