Tuesday, December 27, 2011

Expansive Thinking for Financial Trading

Here's some interesting thinking off someone I had worked with, who once traded the floor over several Asian exchanges.

The Bid/Offer Spread

For a while, a number of intraday trades were liquidity-taking, and we constantly discussed limited transaction costs around size of the bid/offer spread.

Then came the thought "Why can't we be the ones making the spread? (as addition to other edges)" So instead of struggling and crying about this formerly assumed "necessary expense", a whole bunch of great ideas and trades resulted.

Pick offs

The options market making scene has become relatively saturated in Asia, today. Of course for the traditional market maker, a growing risk arises from pick-off frequencies. Pick-offs being the markets moving so fast that effective delta hedging becomes very difficult, even with co-location and etc.

Naturally, everybody wants the good old days back, and many focus on ways to avoid these pick-offs. I believe more progressive, innovative thinking lies in capitalizing off the pick-offs, i.e. WE become the ones doing the pick-offs, and perhaps find ways to exploit the other "pick-off traders".

Innovation is everything

Like all industries, financial trading is no different. No edge/trade lasts forever, hence the need for constant R&D. There is no magic formula that makes money consistently forever. This is why very few private traders make it over time.

Wednesday, December 14, 2011

Market Microstructure Theory by Maureen O'Hara (Book Review)

Market Microstructure Theory preview

Efficient Market Hypothesis is obsolete, Market Microstructure Theory is what's relevant for today's high tech Wall St. scene. Despite the age of this book (1995), the author provides some solid theory and analytical models for the serious market participant. 

Interesting points from the book

Coming from an academic, O'Hara displays a very deep understanding of financial trading along with the nature of price evolutions and "The Nature of Markets". She explores behavior models of market makers, informed, and uninformed traders with respect to auction types utilized.

Inventory Management is a big issue for market makers, or really anyone who applies strategies involving position accumulations.

Game Theory is touched upon, as expected in today's algorithmic trading scene, as big players attempt to outwit each other.

Prerequisites to understanding the models

The models do get relatively technical. This book requires an intermediate understanding in microeconomics, deep understanding in statistics, and some matrix calculus.

Overall conclusion

Though I don't believe the models themselves provide money making solutions directly. Understanding how they work, and figuring out ways to remedy their shortcomings could lead to some brilliant thoughts around trading today's tough markets. Nevertheless, it's an interesting read if anything.