Second, the Market Gods give no prizes for originality.
So you want to know what traders who are taking the game seriously are doing. (Especially with their own money.)
Proprietary trading firms
Hedge fund prop capital
Serious solo traders
Hedge funds
3/n
You are looking for ideas and concepts to apply.
You are NOT trying to copy implementation.
Why?
Because your "small but beautiful" pot of capital affords you opportunities and constraints that are different from others...
An example?
4/n
You find out about a style of trading called "Statistical Arbitrage"
This phrase can refer to many things.
One idea is that we can find assets with similar risk sensitivities, then use relative price moves to determine when a given asset is relatively under/overpriced.
5/n
This thread touches on the idea, with a very simple example:
If we can find occasions where assets tend to diverge and converge to their "equilibrium price" we might be able to get paid, on average, for trading them "back towards equilibrium".
6/n
Standardize. Buy low. Sell high. Offset risk.
There are a couple of reasons these opportunities might appear:
1. Supply/demand for assets can be lumpy and unpredictable - and the impact is not always able to be fully absorbed and offset by normal liquidity providers.
7/n
2. Structural mechanisms by which new information is incorporated in asset prices can lead to lead/lag relationships - where certain assets can "lag" where you'd expect them to be trading, given where peer assets with similar risk sensitivities are trading.
8/n
There's a @macrocephalopod thread somewhere describing this as "big boy pairs trading".
Which is functionally what it is.
Now I imagine you hearing about this for the first time, thinking:
"That seems like a good and useful concept, I wonder how I might apply it?"
9/n
And you get an idea of how stat arb strategies are implemented out in the real world.
10/n
And you learn quant techniques to uncover and model latent relationships in asset return processes in liquid assets.
And you learn techniques to put optimal portfolios together, maximize mispricing opportunities and minimize other risk exposures and trading costs.
11/n
And you think "Boy, I've gotta get myself some of this stat arb quant magic."
But you don't really...
Cos you forgot the most important thing. You forgot to ask WHY...
12/n
Why do those implementations look like that? Why are they working hard to uncover subtle relationships in liquid assets?
Because they have to!
They have lots of capital to put to work in a scaleable quant strategy. It needs to scale.
13/n
You, with your "small but beautiful" pot of capital do not have these concerns.
You can afford to look more directly.
You don't necessarily need to mine for unobservable latent relationships.
With a bit of nouse, you can identify small obvious opportunities.
14/n
Does an ADR trade sloppily enough that you can trade it, with FX hedged, against the stock?
Equity index futures on exchange x and exchange y are nearly the same - but they're noisy enough I can trade convergence.
Similar sh1tcoin futures trade on multiple exchanges.
15/n
These are much more direct expressions of the core idea - of supplying liquidity, on average, to unbalanced supply and demand pressures that can't be absorbed fully by the usual suspects.
You can't get away with this in super liquid markets (anymore)...
16/n
But you don't need super liquid markets.
The people trading at scale would love to be trading this stuff, but they can't.
So your focus needs to be different from the institutional quant trader.
17/n
Your main concerns are less sophisticated quant modelling and more:
- Market smarts to identify opportunities
- A willingness to go into murky places
- Operational effort, attention to detail, good business processes, constant improvement.
18/n
Your problems are more along the line of:
- how do I access Thai futures?
- how do I deal with trading holidays across timezones?
- how do I manage collateral across crypto exchanges?
- how do I execute a cross-venue spread for the best price with the least leg risk?
19/n
If you're serious about trading small capital, you can afford to get your hands dirty
Don't emulate big money when you don't have their constraints.
In the original thread we noted:
- you can't trade VIX
- so there's no market mechanism to stop it from being predictable
- but VIX futures do trade and their price incorporates where the market thinks VIX is likely to go
2/n
If the market thinks VIX is going to go up, the futures will likely already be trading at a premium.
Sellers won't sell low if it's likely to go up.
Buyers will be happy to buy higher if it's likely to go up.
If you're an experienced trader, you'll recognize immediately that this is not a thing you can trade.
Why?
Cos it wouldn't look like that if people could trade it.
2/n
Cos, just by eyeballing the time series chart, you can tell VIX is very predictable:
- It stays about the same in the short term
- But if it's low it's more likely to go up
- And if it's high it's more likely to go down
- It has a floor under which it's unlikely to go lower
For most of my time, I just thought of tail hedging as the "cost of entry".
A "ticket to the dance" if you like.
You can't predict what happens in the tails - so pay up to cover them & go play hard in the peak of the bell curve, where your tools and models are most valid.
If you're a good trader, you'll tend to find that your highest expected return opportunities appear after massive moves.
Disconnections happen when others risk models are flashing red and they are FORCED to trade (rather than want to).
In the "win-lose" games of active trading, your "edge" comes from:
- Buying from someone too cheap
- Selling to someone too expensive
At least on average.
To do this, you need to know who you are playing against.
🧵on "edge", where to find it, and how you can compete 👇
1/n
If you are a market maker, it is relatively clear to understand who you are trading against.
If you're a positional trader, it is perhaps less clear.
On a trivial level, you're probably trading with a market maker.
2/n
But understand that "the market line" is set by the supply/demand pressures of other aggressive traders.
- End users (wealth mgmt, retail)
- Aggressive prop traders doing short term risky arbs
- Informed positional traders with pricing models + (maybe) info advantages
3/n