What is a trader's objective and how can they justify not speculating?
Hi,
Probably a really stupid question but struggling to get my head round it. Obviously the Volcker rule puts restrictions on banks to prop trade, or more broadly take speculative positions. But how exactly does this work in practice?
As a market maker you have to hold inventory. If a client order comes in, you can either take the other side of the position and manage the risk, or you find somebody else to take the other side. Though I imagine until you find somebody else to take the other side, you probably have to hedge in the interim (especially if the product is less liquid).
But my question relates to having to hold inventory and managing that risk. Excluding fee income and bid-offer spread (which we can ignore in the context of this question), I'm wondering whether desks make money through speculation.
Say you're an equity derivatives desk, what's the trader's objective? Is it #1 or #2 or neither?
1 To be as perfectly hedged to each of the greeks as possible.
If the objective is just to have as little risk as possible, how do you avoid speculation? In a real world you can't have zero risk to each of the greeks (i.e. can't be completely delta hedged, completely vega hedged etc.), so you'll end up with some residual risk. It could turn out after hedging that you're slightly long vega. Equally it could turn out after hedging that you're slightly short vega. But surely that's taking a speculative position, because you're choosing whether you want to be long or short vega based on your view of the market i.e. "My aim is to reduce risk as much as possible but if I have to have some residual risk I'm going to make sure I'm long vega because I reckon there will be a big correction in the next few days". Your choice of residual risk is then based on speculation.
2 You can speculate as much as you want so long as you are making the market and are operating within your risk limits (speculation within parameters)
As a market maker you hold inventory. You obviously hedge the positions that you have to hold. As long as you aren't breaching limits, can you do whatever you want based on your view on the market? So going back to my above example if you think the SPX will exhibit a correction, can you make sure you're as long vega / volgamma as possible, without breaching any risk limits?
So pretty much speculating as much as you want (within parameters) through your hedging, so long as in the process you are also market making?
So yeah I guess two questions:
Firstly what is the trader's aim? Is it #1 or #2?
Secondly, depending on whether it's #1 or #2, how can that be justified as non-speculative? Especially in the case of #2. It seems in either a trader can use its hedging to speculate... because there'll always be residual risk.
Just try to understand the nuts and bolts of it all.
Thanks!