20 Things to Do Before You Ask for a Price (Part 1)

[00:00:01] Hello, this is Dean Curnutt and welcome to the Alpha Exchange, where we explore topics in financial markets associated with managing risk, generating return, and the deployment of capital in the alternative investment industry.

[00:00:19] The election is over. The vol risk premium across asset classes and around the world has largely disappeared. VRP, we hardly knew ye.

[00:00:29] To be sure, these macro events of consequence can lead to a lot of gamma. Think about it. There's a day on the calendar months and months ahead.

[00:00:38] The VIX futures curve showed an October hump as early as February. The election season grinds on and on and on.

[00:00:46] And it all gets resolved on the first Tuesday in November. Asset markets move and vol deflates. USTs go down, Bitcoin go up.

[00:00:55] Lots of action in markets, but no asset class has experienced more gamma than that business we all love to hate, political news media.

[00:01:05] I mean, imagine being Joe Scarborough, getting your hair quaffed for your four-hour marathon of a show on November 5th.

[00:01:13] You've read with delight the shocking Iowa poll that showed Harris ahead of Trump.

[00:01:18] Oh, the many implications.

[00:01:20] You're thinking throughout the day about what the next four years is going to look like and the important role you and your team will play in putting the new democratic administration in the most favorable light.

[00:01:31] You hope to be invited to the celebratory festivities.

[00:01:35] And then, most suddenly, as high gamma situations do, you've got to flip your stance entirely and in a short period of time.

[00:01:43] You've been up all night.

[00:01:45] You prep for the November 6th show with a bit of edge, contemplating the outrage you'll soon express.

[00:01:51] All at once, you realize that your next four years is going to be entirely different from what you thought it would be just a day ago.

[00:01:59] Two channels up on Fox News, Sean Hannity is having a similar but opposite experience.

[00:02:05] No one was more short gamma than the media.

[00:02:09] With that most irrelevant introduction, honestly, folks, I'm not even sure where I came up with that.

[00:02:15] I wanted to welcome you to a new four-part series of the Alpha Exchange, 20 Things to Do Before You Ask for a Price.

[00:02:23] Since our listening community is a mathy bunch, I don't have to tell you that four parts of 20 things means five things per part.

[00:02:33] What you ask are the 20 things to do and why must you do them before you ask for a price?

[00:02:40] In short, this is my thinking on what a salesperson ought to instinctively and nearly instantaneously do in his or her interaction with a trader colleague being asked to price option risk for a client.

[00:02:54] These 20 things constitute a real-time checklist, a real-time to-do list for the salesperson that adds Alpha to the process of price discovery

[00:03:03] and can allow the trader to take more risk by mitigating certain kinds of risks.

[00:03:09] Let me explain.

[00:03:10] I've been at this sell-side business thing for more than three decades now.

[00:03:15] At 55, I'm still standing, as Sir Elton told us four decades ago.

[00:03:20] Along the way, I've seen all kinds of stuff on trading floors.

[00:03:24] Eating and push-up contests, near fights, keyboards smashed, vociferous laughter, the good, the bad, and the ugly, and lots and lots of trades.

[00:03:34] I must say that the successful transfer of risk from one willing counterparty to another is a beautiful thing.

[00:03:41] Trade is what makes the world go round.

[00:03:44] Trades can be zero-sum.

[00:03:45] A buyer of all will surely enjoy profits if a decided risk-off ensues shortly after an option trade is consummated.

[00:03:53] The seller will nurse losses.

[00:03:55] As Will Emerson said in Margin Call, your loss is my gain.

[00:03:59] Risk transfer, especially in sizable notionals, is an adult swim exercise.

[00:04:06] And because there's a lot at stake, the process, most often involving three individuals, the client, the salesperson, and the trader, needs to be a reliable one.

[00:04:16] There ought to be rules of the road, implicit but well understood, where two counterparties can engage in a large financial transaction.

[00:04:24] For my part, running a sales desk and keenly aware that one can't pay bonuses out of those magical chits called sales credits,

[00:04:33] 20 Things is about what I brought to each trade I was a part of and what I expected folks on my team to bring as well.

[00:04:41] After all, a $10,000 lot in which the trader lost a million dollars and the salesperson was paid $30K in commission wasn't exactly time well spent for the team.

[00:04:50] There's only one way to make $30K in commission, but there are countless ways to lose a million dollars, through Delta, Gamma, Vega, even dividends.

[00:05:01] 20 Things was about the salesperson playing a role in risk management alongside the trader who would ultimately bear the risk, of course, but needed a partner in the price discovery process.

[00:05:12] For me, the salesperson has always been a critical aspect of getting the right looks at trades and quarterbacking them to completion that left both the client and trader feeling like what just happened made sense and that they'd willingly engage again at a future time.

[00:05:28] As part of this, managing to a consistent set of expectations was an ingredient to success.

[00:05:34] The options flow business is all about repeat transactions.

[00:05:37] You simply can't have too few clients and you can't be overly concentrated in one type of risk.

[00:05:44] That just doesn't make for a sustainable business.

[00:05:47] Flow, as they call it, is just that.

[00:05:50] It's about motion, frequency, and lots of interaction.

[00:05:53] And with those, plenty of opportunity for mistake and financial loss, which no one likes.

[00:05:59] That's the intro.

[00:06:00] So what are the 20 things?

[00:06:03] Let's get the first five done over the next 10 minutes.

[00:06:06] The first is so basic that it's almost self-evident.

[00:06:09] But thing number one is to know your client.

[00:06:12] But in the context of a fast-paced, high-risk trade that presents itself in a moment's notice and maybe consummated moments after that, knowing the client is beyond critical.

[00:06:24] When that light rings, it has got to set off a chain of thoughts in your head before you even hit it.

[00:06:30] What is this client's MO?

[00:06:32] What is his relationship to the desk?

[00:06:34] When's the last time he traded?

[00:06:36] How did it go?

[00:06:37] This starting point is a critical component of quarterbacking in the price discovery and execution process.

[00:06:42] Every client is unique.

[00:06:44] Your job is to appreciate that uniqueness to the extent possible.

[00:06:48] As you pick up the light, you are simultaneously thinking about thing number two, which is knowing the risk environment.

[00:06:55] Is the VIX at 10, 20, or 40?

[00:06:58] Is it rising or falling?

[00:07:00] What's the liquidity environment on the street?

[00:07:02] Are dealers widening or tightening?

[00:07:04] Is it 150 on an FOMC day?

[00:07:07] You should be armed with a strong appreciation for the risk backdrop so you can set expectations on what is or isn't feasible in the current climate.

[00:07:16] So, both thing one and thing two you've done even before you've actually engaged with the client.

[00:07:22] You've instinctively thought about the client and his motivations, expectations, and relationship to the desk.

[00:07:28] You've also got a strong view on the market, risk, and liquidity conditions under which a trade may occur.

[00:07:34] You've now hit the light, and wouldn't you know it, the chap on the other end of the line has a trade for you to look at, and gosh darn it, it's not of the best way variety.

[00:07:43] He wants capital.

[00:07:45] These clients are a demanding bunch, aren't they?

[00:07:48] What is thing three I know you cannot wait to learn?

[00:07:52] It's the motivation for the trade at hand.

[00:07:55] Is the client buying or selling vol?

[00:07:57] Is the trade opening or closing?

[00:07:59] Even with a request for a two-way market, it really ought to be the case that you've got a good idea on direction.

[00:08:06] That circles back to understanding your client, knowing how they think about risk, and oftentimes having a good idea as to what they already have on.

[00:08:15] Let's use an example.

[00:08:17] You've got your trader short calls on NVIDIA through a client all jazzed up on AI.

[00:08:22] As poor luck would have it, this beast of a company added $500 million of market cap in a few short weeks, and the option implied vol rose along the way.

[00:08:33] That tricky stock-up, vol-up episode I've spoken about.

[00:08:38] Said client calls looking for a two-way on the same position he's already in with your desk.

[00:08:43] Is he adding or unwinding?

[00:08:45] It would be nice to know.

[00:08:47] Think about it from your trader's risk manager perspective.

[00:08:50] He's in a losing trade.

[00:08:52] He's either unwinding it or doubling the size.

[00:08:56] Pretty different scenarios to entertain.

[00:08:58] Would you concur?

[00:08:58] The salesperson should be thinking about this risk also.

[00:09:02] Every client is different, but most, if you know them really well and they value your contribution to their business, will probably tell you which way they are.

[00:09:11] That contribution is about providing consistent, valuable service over a sustained period of time.

[00:09:18] You may have earned the right to simply ask.

[00:09:21] But if it's two-way or the highway, then bring back your informed view on whether this is an unwind or an add to the trader.

[00:09:29] Clearly, there are some tells.

[00:09:30] If the client bought 14,723 NVIDIA April 150 strike calls to open and asks for a price on 14,723 April 150 calls, they are probably either pretty sneaky, sis, or telling you that they are closing without telling you they are closing.

[00:09:53] So, again, thing three is all about what motivates the trade and the person on the other end of the line.

[00:09:59] An appreciation for how they think about risk is really important.

[00:10:03] Some folks cut quickly.

[00:10:05] Others use losses to add at better levels.

[00:10:08] And let's not forget that when a client is specifically acting on your advice,

[00:10:12] Hey, I think the vol is interesting here.

[00:10:15] Let's buy some.

[00:10:16] Then you clearly know what they are doing and can communicate with great specificity to the trader.

[00:10:22] If you're simply a cog in the wheel of capital commitment, you'll have much less idea as to what the client is up to.

[00:10:28] If you, in contrast, are actively involved in the client's trade construction process,

[00:10:34] you'll have a great sense as to what direction they are doing when quoting.

[00:10:38] Thing four is about the underlying asset.

[00:10:41] What's the stock?

[00:10:42] Is it Nestle or Netflix?

[00:10:44] Low vol or high vol?

[00:10:46] Is there any news out on the stock?

[00:10:48] Is that stock liquid?

[00:10:50] Is it trading with heavier volume than normal?

[00:10:53] What's the percent move on the day?

[00:10:54] Just having an appreciation for the asset you're dealing with is important to internalize.

[00:11:00] As the client is relaying the order, you're using all kinds of Bloomberg functions to get context.

[00:11:06] GPO for price and volume.

[00:11:08] Comp for return.

[00:11:09] D-E-S to simply know what the heck the company does.

[00:11:14] And to this last point, there are plenty of trades in the Triple Q and NVIDIA and Exxon,

[00:11:20] but there are countless really off-the-run names that clients are active in,

[00:11:24] but you may never have heard of.

[00:11:26] Thing five is to buy yourself some time.

[00:11:29] If this is an uncommon name, repeat the ticker back to the client in a way that makes it clear that you don't

[00:11:35] and probably shouldn't know the name.

[00:11:38] Maybe the interaction goes like this.

[00:11:40] Hey, VITL, Jan 30 calls, mark it on 2K.

[00:11:44] And you come back with VITL.

[00:11:48] Well, okay, VITL farms.

[00:11:51] Huh.

[00:11:51] A range of ethically produced foods.

[00:11:54] Interesting.

[00:11:55] I've not looked at this before.

[00:11:57] So what this does is stall a little bit so you can look at the OMON screen,

[00:12:01] but also set expectations and make it clear that this isn't Microsoft.

[00:12:06] It may set you up to do what salespeople ought to strive always to accomplish,

[00:12:11] under promise, over deliver.

[00:12:13] Well, that is the first five of the 20 things to do before you ask for a price.

[00:12:19] Know the client.

[00:12:21] Know the risk environment.

[00:12:22] Have a view on what motivates the trade.

[00:12:25] Think about the stock itself and buy yourself a little bit of time.

[00:12:29] There's much more to come your way,

[00:12:31] and we'll get into the weeds on how the salesperson can contribute valuably

[00:12:35] to the process of successful, safe risk transfer on behalf of the trader.

[00:12:40] Until next time, have a great week.

[00:12:43] You've been listening to The Alpha Exchange.

[00:12:46] If you've enjoyed the show, please do tell a friend.

[00:12:49] And before we leave, I wanted to invite you to drop us some feedback.

[00:12:52] As we aim to utilize these conversations to contribute

[00:12:55] to the investment community's understanding of risk,

[00:12:58] your input is valuable and provides direction on where we should focus.

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[00:13:07] Thanks again, and catch you next time.