Stayin’ Alive

High-frequency trading firms were thrust into the public spotlight when Michael Lewis published his book Flash Boys in 2014. The arc of the book was that proprietary trading firms had invested heavily in technological infrastructure to increase the speed by which they received financial market trading and execution data. They would use this speed advantage to exploit market structure dislocations on various stock exchanges, profiting from the otherwise uniformed traders plagued by slower access to the exchanges. The opinion of Lewis was that these proprietary high-speed trading firms were extractive for society, pushing up the cost of execution for other institutional traders such as pension funds, thereby disadvantaging main street and retirement savings accounts. Not surprisingly, there was push back from the industry. Many advocates of high-frequency trading firms argued that they were simply providing a liquidity service for which they were compensated and, with the increased liquidity, equity transaction costs have been lowered to the benefit of the investing public. Like many things in life, the truth is likely somewhere in between these two extremes.

Without getting too nuanced, Jane Street is a proprietary trading firm that specializes in making markets for several different asset classes. Jane Street’s rise to fame in the trading world was through making markets in ETF products. This article on understanding the business model of Jane Street is an interesting one, but not necessarily to do with the debate on whether high-frequency market makers provide value to society. What I found interesting was the discussion around Jane Street’s risk management process and the illustration of how using a strategy that, despite having a negative expected return profile, can still be integral to the livelihood of the firm. Keeping this discussion high level, as a market maker your provision of liquidity to the market is like being short an option. You are essentially capturing a small bid/ask spread for the provision of liquidity and hoping you don’t get run over by a steamroller; the steamroller being someone that has informed flow, or perhaps just a broad risk-off crash where you have warehoused inventory. The informed flow is a harder question to tackle, but it’s why high-frequency trading firms like Citadel will pay to make markets for the “uninformed” Robinhood flow. For the market crash risk aspect, the article goes into Jane Street’s strategy of buying out-of-the-money (OTM) put options and rolling them on a consistent basis. Paying for OTM put options as insurance for market crashes has been shown to have a negative expected return on a stand-alone basis; however, for Jane Street the key is how this strategy interacts with the rest of its business. For Jane Street, it is invaluable to be well capitalized when markets crash, as liquidity dries up and bid/ask spreads widen to compensate for the increased risk. This is a time when the most profitable trades arise for market makers, so it’s integral to have the capital to put to work in alpha-producing ventures. So, even though the strategy of naively buying OTM put options may be a money-losing proposition on its own, as part of Jane Street’s corporate portfolio, the combination of the tail-risk strategy allows the firm to reap the benefits of the influx in capital at just the right time.

This is how we would encourage all investors to think about risk management strategies, whether it is an options tail-risk strategy, multi-asset trend, or the addition of commodities to an inflation-sensitive portfolio. These strategies are designed to not only minimize volatility drag that impairs the ability of portfolios to compound in future periods thereby reducing the overall terminal value, but it also allows investors the ability to put capital to work at precisely the time when there are increased opportunities to realize alpha. Therefore, you can have a strategy that, on an individual basis, experiences a negative expected return (insurance buyer), but when combined with a strategy that has a positive expected return that is negatively affected when the insurance strategy pays out, the addition of the insurance strategy can increase the expected return of the total portfolio. An underrated aspect of portfolio management is the obsession with risk profiles, and the benefits of having a “cockroach” portfolio that can stay alive through anything.