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:
- 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 Futures1027446178AM J J A SO ND J FM
Daily Values Source: CBOETHE EQUITY-ONLY PUT-CALL RATIO
Put-Call Ratio S&P 500 Index4580115150185220255290AM J J A SO ND J FM
Source: McMillan Analysis Corp.SPX SKEW
Implied volatility %78910111213141516%AM J J A SO ND J FM
Source: Credit Suisse Equity Derivatives StrategyNDX SKEW
Implied volatility %891011121314%AM J J A SO ND J FM
Source: Credit Suisse Equity Derivatives StrategySkew 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