Barron\'s 03.16.2020

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March 16, 2020 BARRON’S M7


THE STRIKING PRICE


Traders and investors should attempt to be


liquidity providers, not consumers, and use


strategies common to market makers.


When Markets Are Wild,


Embrace Liquidity


L


iquidity is a fickle companion.


Seemingly ubiquitous under most


circumstances, it has a way of be-


coming scarce when most needed.


The recent wild gyrations in markets—in-


cluding in stocks and options—have caused


many traders to reassess their assumptions


about liquidity. In the current environment,


traders and investors should attempt to be


liquidity providers, not consumers, and use


strategies common to market makers.


The dictionary definition of liquidity is


“the availability of liquid assets to a market


or company.” That definition, however,


refers to corporate and personal balance


sheets and is a poor explanation of market


liquidity. In financial markets, liquidity is


better understood to be the ease with which


an asset can be traded with little effect on its


price. Liquid markets show large bid and


ask sizes at tight spreads, making it simple


for traders to buy and sell their desired secu-


rities or derivatives with little price impact.


There is a nasty feature of liquidity that


has revealed itself over the past few weeks:


It is often inversely proportional to volatility.


This is a direct result of how market makers


operate. Market makers are traders who


commit to post continuous bid and ask


prices in their assigned products, and thus


are key providers of liquidity. They implic-


itly agree to be subject to negative selection—


in other words, doing the trades that others


initiate—in exchange for a better chance at


capturing bid/ask spreads.


Every financial transaction needs to bal-


ance risk and reward, and market makers


must strike that balance countless times a


day. Realizing that every one of their posted


bids and offers could lead to a trade, market


makers use a calculus that optimizes the


capital they are willing to commit.


When markets are functioning normally,


it is relatively easy for market makers to be


confident that their prices are reasonable,


and that undesirable or risky positions can


be reversed or hedged with little difficulty.


By “normal,” we mean that prices move


somewhat continuously in modest trends,


with relatively balanced trading between


bid and ask prices. If the order flow be-


comes overwhelming in one direction or


another, it changes the risk/reward calculus.


What is the market maker’s strategy in


such a situation? Many years ago, before this


was fully programmed into our models, we


had a big sign in our trading room remind-


ing us what to do when markets turned ugly:



  1. Widen quotes, 2) Shrink sizes, and 3)


Raise volatilities.


This is what market makers do in dis-


jointed markets, and what you should do, as


well. You can accomplish that by trading


smaller sizes and demanding more profit for


each of your trades. If you normally trade 10


options contracts, trade fewer. Don’t be he-


roic when prices are moving rapidly in one


direction or another. Successful market


makers are very disciplined about taking


profits and losses, and, while every options-


market participant should be keenly aware


of risk and reward, volatile markets require


exceptional vigilance.


Now is the time when you can be the one


who is paid to add liquidity by using limit


orders inside the posted quote. Rapidly mov-


ing markets usually feature wider bid/ask


spreads and/or smaller posted sizes. Small


investors and traders should avoid hitting


bids or lifting offers that cross large posted


spreads, along with market orders, which


should be avoided entirely, since they con-


sume liquidity. When you set the bid or of-


fer, you are providing liquidity. You benefit


from others crossing the spread to trade


with you at your chosen price.


And by all means, avoid consuming li-


quidity by being forced into trades to cover


margin calls. It is safer to eschew margin


borrowing in volatile markets. An adage


states, “Trade when you can, not when you


have to.” Thinking and acting like a market


maker can help you meet that goal.B


Steve Sosnick is chief strategist at Interactive Bro-


kers and head trader of its Timber Hill subsidiary.


By Steve Sosnick


Equity Options


CBOE VOLATILITY INDEX


VIX Close VIX Futures

10

27

44

61

78

AM J J A SO ND J FM
Daily Values Source: CBOE

THE EQUITY-ONLY PUT-CALL RATIO


Put-Call Ratio S&P 500 Index

45

80

115

150

185

220

255

290

AM J J A SO ND J FM
Source: McMillan Analysis Corp.

SPX SKEW
Implied volatility %

7

8

9

10

11

12

13

14

15

16%

AM J J A SO ND J FM
Source: Credit Suisse Equity Derivatives Strategy

NDX SKEW
Implied volatility %

8

9

10

11

12

13

14%

AM J J A SO ND J FM
Source: Credit Suisse Equity Derivatives Strategy

Skew indicates whether the options market expects a stock-market advance or decline. It measures the difference
between the implied volatility of puts and calls that are 10% out of the money and expire in three months. Higher
readings are bearish.

Week'sMostActive
Company Symbol TotVol Calls Puts AvgTotVol IV%ile Ratio
Private Equity ETF PSP 7883 33 7850 196 100 40.2
Spain ETF EWP 33764 147 33617 1692 100 20.0
Tegna Inc. TGNA 29019 26456 2563 1668 100 17.4
The Habit Restaurants HABT 9358 397 8961 624 16 15.0
Enable Midstream Partners ENBL 14419 9233 5186 1092 99 13.2
Synchronoss Technologies SNCR 14924 67 14857 1280 100 11.7
Crude Oil Total Return ETF OIL 9169 5529 3640 984 100 9.3
Endurance Int'l EIGI 7559 669 6890 1040 100 7.3
Colony Capital CLNY 18300 7590 10710 2748 100 6.7
Cypress Semiconductor CY 54074 39656 14418 8188 13 6.6
Italy Index Fund ETF EWI 74324 513 73811 11412 100 6.5
France Index Fund ETF EWQ 6963 7 6956 1080 100 6.4
Enzo Biochem ENZ 9743 8552 1191 1712 99 5.7
UK Index Fund ETF EWU 61480 3872 57608 11028 99 5.6
Oil & Gas Triple Bullish ETF GUSH 84683 80310 4373 15936 100 5.3
Chimera Investment CIM 33542 2024 31518 6628 97 5.1
CenterPoint CNP 35825 4786 31039 7312 100 4.9
MGM Resorts MGM 745825 641554 104271 160740 100 4.6
TeeKay Corp. TK 4683 3350 1333 1020 100 4.6
Australia Index Fund ETF EWA 128465 1133 127332 28640 100 4.5
Thistableofthemostactiveoptionsthisweek,ascomparedtoaverageweeklyactivity–notjustrawvolume.Theideaisthatthe
unusuallyheavytradingintheseoptionsmightbeapredictorofcorporateactivity–takeovers,earningssurprises,earningspre-
announcements,biotechFDAhearingsordrugtrialresultannouncements,andsoforth.Dividendarbitragehasbeeneliminated.In
short,thislistattemptstoidentifywhereheavyspeculationistakingplace. Theseoptionsarelikelytobeexpensiveincomparisonto
theirusualpricinglevels.Furthermore,manyofthesesituationsmayberumor-driven.Mostrumorsdonotprovetobetrue,soone
shouldbeawareoftheseincreasedrisksiftradinginthesenames
RatioistheTotVoldividedbyAvgTotVol.IV%ileishowexpensivetheoptionsareonascalefrom0to100.
Source:McMillanAnalysis
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