Guest Post: Managing the War Between Hedgers and Liquidity Providers, by @eradke

2 Nov

The following is from the perspective of a futures trader but can be applied to all markets.  Being a trader in 2008 was great; being an investor was not so great.  Today it is not that forgiving for either side.  I was naïve to think that 2008 was not going to last forever.   I knew where the money was coming from, the retirement accounts of my fellow citizens of the World.  You can make a moral judgment if you want, but it was my job to provide liquidity.  I could have lost it just as easy.

In early 2009 I saw the markets changing.  It blew out a lot of people.  I walked away for six months.  It was depressing, people I saw every day just disappeared.  The biggest problem with trading is that you can never really spend the money.  For an independent trader, you are the business.  What the average person sees as cost of living, it is our overhead.  Despite working with money every day most traders are not that good at managing it.  They look at as an income, something constant, when it is really is just a bonus check.  When the market changes, there is natural attrition.

The top of the food chain in markets are institutions, followed by professional traders, and lastly retail.  The first people to leave are the retail.  Retail does not like to lose money; they do not have the wherewithal to figure out why.  When retail goes away professional and institutional traders pick on the weakest traders.  Eliminating another class of market participant.  As the range becomes tighter and volatility slows the top professional traders leave.  How motivated would you be if you had to go to work making 5% of your normal pay and it cost you the same amount to get to work?

When everyone is making money there are no problems.  But when the pie gets smaller, participants fight for their survival.  They become animals fighting for what seems like their last meal.  They run out of money, they feel the game is rigged, or they feel there is no upside in taking the necessary risks.  If participants stay away for an extended period of time the mechanics of the market change.  When this happens, the market cannot perform its function.  Price discovery, raising capital and hedging.

The easiest way to get people back in the market is for the markets to rally.  That is why none of the underlying fundamentals matter, at least right now.  Rallying is the only way for the market to repair itself.  The problem is when it does rally those that were long will use the new money to get out.  If there is not more new money we will break again.  A market is as proportionately functional as the willingness and amount of participants in said market.  The most efficient way to get participants back is a feeling they are missing out, ie rallying.  This is also expensive.

The other way and most destructive way to keep liquidity providers in the markets is by “volatility jumping”.  As we saw with the equity index markets this is destructive and it is the largest market.  It causes the price of commodities to rise, oil, corn, meats, etc.  It can be done with less money because there are less people trying to make it efficient.   Instead of taking money from retirements they take it from the businesses providing goods.  In most cases it is passed on to consumers in the form of higher prices.  That will end badly.

The CME Group, NYSE, etc are making dangerous assumptions.   Much like the market assumed housing prices would continue to rise forever; we are assuming the market is going to continue to have liquidity providers and hedgers. People like me, take advantage of inefficiencies.  We make the market efficient, when the risks are close to the rewards.  We watch otherwise.

The biggest change from the past is that the major American exchanges are now corporations.  Their motivation is to profit, they do this by increasing volume.  It is their fiduciary responsibility.  There has been a shift of advantages, in terms of commission breaks, to retail investors.  They are sacrificing quantity for quality.  A constant stream of one night stands and sport fucking.  As I mentioned before retail leaves first.   A problem for efficient markets.

I recently attended the World of Opportunity Event at the CME Group.  The panel consisted of Scot Warren, Managing Director, Equity Index Products & Services — CME Group, Tim Gits, Senior Vice President and Head of Sell Side Relations — Eurex, Raj Chopra, Director, Corporate Development — ICE and Marco Bianchi, Senior Vice President & Head of Business Development — NYSE Liffe.  I was curious to see where they thought the new opportunities were/are.

All four panelist were really good, Scot Warren was an exceptionally great communicator.  One of the topics they failed to talk about is hedger and liquidity provider relations.  This is a real problem.  I am sure they are addressing the problem but to my knowledge not publically.

I am always considering who is on the other side of my trade.  What time frame are they using?  Are they retail, another professional, or an institution?  Are they accumulating a position or are they scalping?  I am beginning to wonder if there will always be someone.

By Eli Radke

www.traderhabits.com

www.twitter.com/eradke

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3 Responses to “Guest Post: Managing the War Between Hedgers and Liquidity Providers, by @eradke”

Trackbacks/Pingbacks

  1. Managing the war between hedgers and liquidity providers. | MyTradingNetwork.com/blog - November 2, 2010

    […] Managing the war between hedgers and liquidity providers. Written on November 2, 2010 by Eli Radke in General url='http://mytradingnet.com/blog/2010/11/02/managing-the-war-between-hedgers-and-liquidity-providers/';username='@traderhabits';I was lucky to have had an opportunity to write a piece for StoneStreetAdvisors.com. You can check it out here. […]

  2. Wednesday links: sugar highs Abnormal Returns - November 3, 2010

    […] Eli Radke, “The biggest change from the past is that the major American exchanges are now corporations.  Their motivation is to profit, they do this by increasing volume. “  (Stone Street Advisors) […]

  3. Things I read so you do not have to. | MyTradingNetwork.com/blog - November 14, 2010

    […] is not gone, it just has changed.  The exchanges will have to solve the problem between the liquidity providers and hedgers.  Giving preferable treatment to those that make them the most money.  Right now, in my opinion, […]

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