How to Make Money in The Market: Providing Liquidity

Martinghoul's picture
Rank: Neanderthal | 3,640

Since you brought it up - what is your edge?

I am really a liquidity provider of last resort, with occasional forays into macro.

Certainly lots of people can or are willing to provide liquidity in your world, no?

So let me start by saying that I believe that there are only two ways of making money in the mkt. They are:

**A) accurately predicting the future; and B) providing liquidity.**

In the famous words often attributed to Mark Twain, "it's difficult to make predictions, especially about the future". Moreover, it's even harder to make such predictions in the mkt, where you have to not only be right about the future, but also about when this future will be realized. On top of that, you have to make sure that you survive all the mkt fluctuations in the interim. So method a), which is what most people refer to when they talk about "old-school" macro, is really really hard, especially in this day and age. On the other hand, b) is kinda hard, but it's not really that hard.

So, based on the above, my edge is using distortions in the rates mkts (created by large, somewhat price-insensitive flows) to put on trades, which allow me to make bets on the future with favorable risk/reward characteristics. If you're careful and diligent and have some experience in these things, you could construct a "neutral" portfolio that should perform in a majority of future scenarios and, most importantly, will be relatively timing-insensitive. This, I guess, is sorta similar to the basic premise behind a typical long-short equity book. It's the "relative value" element, if you will. Furthermore, if you do feel the urge to actually bet on a particular future outcome and you have a selection of trades to play with, you can also adjust the relative weightings in your portfolio to "skew" it in your preferred direction.

Obviously, this process has certain costs and disadvantages. Specifically, the resulting portfolio is likely to be quite leveraged. It also won't be anywhere as liquid as "old-school" macro, although I personally don't think it's such a big deal.

So this is it, in a nutshell. Hope it helps.

Mod Note (Andy): Top comments - this comment was originally posted in the AMA "HF PM AMA"

Comments (16)

May 16, 2017

there's no way to create an absolute delta one (i.e. fully neutral) portfolio. of course you can get close.

on the point of liquidity, are you referring to market making? because that's where the real money is. look at Citadel.

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May 17, 2017

I am not really sure what you're referring to,

And no, I am not referring to explicit mkt-making, since that's a very different business model.

Best Response
May 17, 2017

I honestly don't know wtf you're talking about half the time but you're one of the best info providers on this site. +1

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May 18, 2017

Your +1 investment got you +4 returns already, so I think you secretly know what he's talking about :)

    • 1
May 21, 2017

Reminds me of will ferrell in anchorman: "you know i dont speak spanish, Baxter, in English pls"

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May 17, 2017

How do you manage rolldown/carry?

May 18, 2017

carry/roll is a very important input into the various calculations that allow me to figure out the ex ante attractiveness of a given trade. Once a trade is in a portfolio, carry and roll has to be monitored, obviously, in order to ensure that all the assumptions continue to hold.

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May 18, 2017

Say you wanted to pay the fixed and receive the floating on a play that could take some time to come to fruition. What kind of tenor would you look at / how could you position to minimise how much you lose on carry/rolldown untill rates move?

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May 17, 2017

Two questions:

1) Isn't there still some future prediction involved in your "liquidity provider" approach? I'm assuming you're not hedged against every possible market move, so you'd need to decide what your portfolio structure is implicitly tilting towards based on your view of the future

2) I'm assuming your "liquidity provider" strategy involves high transaction costs. How do you manage that and optimize?

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May 18, 2017

1) Absolutely and it's a fine balance, undoubtedly. As you say, hedging against every possible outcome is impossible. Furthermore, it becomes impractical to hedge too much well before you cover even a handful of scenarios. So, undoubtedly, you have to take risk. Obviously, as you get more senior and experienced, you become more comfortable with risk and you get to run more of it.

2) Well, transaction costs are undoubtedly a concern, although "high" is a very relative term. Transaction costs are undoubtedly higher than if you were punting extremely liquid instruments. On the other hand, there's a lot more edge. So, again, there's a fine balance that needs to be negotiated and that's a skill that one has to hone over the years.

P.S.: I've just realized how prone I am to using the same word in a paragraph over and over again. It's, undoubtedly, not great.

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May 18, 2017

Trend followers don't try to precit the future, nor limit themselves to providing liquidity, they still make money apparently.

What's your take on them?

May 18, 2017

Do they? I mean do they make money? In a risk-adjusted sense?

If I (very briefly) look at the data, I can observe, at best, that systematic strategies broadly produce similar performance to "relative value", but with a lot more volatility (based on arnd 30y of performance history). More recently, looking at the performance of the various systematic strategies post-crisis, the overwhelming majority of them produce a Sharpe ratio of well below 1. The big, famous and (maybe) good ones are able to produce 1 or slightly better. Furthermore, their max drawdown characteristics don't make them look a lot better than the others and that, at least post-crisis, was a big selling point.

So, to put it gently, I just not 100% convinced. Two caveats apply to what I've written above:
1) I am not sure how to look at "trend followers" specifically, so I used data for a broad set of systematic strategies/CTAs.
2) To be fair, the 2008 experience is a meaningful one and argues very strongly in favor of systematic. Every investor should weigh this consideration vs what I've mentioned above and make their judgement.

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May 18, 2017
<span itemprop=name>Martinghoul</span>:

Do they? I mean do they make money? In a risk-adjusted sense?

If I (very briefly) look at the data, I can observe, at best, that systematic strategies broadly produce similar performance to "relative value", but with a lot more volatility (based on arnd 30y of performance history). More recently, looking at the performance of the various systematic strategies post-crisis, the overwhelming majority of them produce a Sharpe ratio of well below 1. The big, famous and (maybe) good ones are able to produce 1 or slightly better. Furthermore, their max drawdown characteristics don't make them look a lot better than the others and that, at least post-crisis, was a big selling point.

So, to put it gently, I just not 100% convinced. Two caveats apply to what I've written above:1) I am not sure how to look at "trend followers" specifically, so I used data for a broad set of systematic strategies/CTAs.2) To be fair, the 2008 experience is a meaningful one and argues very strongly in favor of systematic. Every investor should weigh this consideration vs what I've mentioned above and make their judgement.

They admittedly never get good ratings in sharpe ratio, which you can argue makes their strategy high risk.
However they point out that their durability through the decades without being wiped out combined with the high return ratios in terms of absolute returns, compared to strategies which got significantly better sharpe ratio yet ended up being wiped out at various times, notably the big market drawdowns of 97 and 2008, puts the validity of relying on that sole indicator under question.

To me that makes sense. Note that I'm taking all of this from ''Trend Following'', which I'm reading these days and I haven't finished yet, it'll take a week or so, so I might be able to give you a more accurate reply later, but that was the argument presented in the book when the author presents the criticism to the strategy.

You can argue you prefer your market making strategy, because it's more risk averse and goes better with Buffet's n.1: ''never lose money'', but in that respect then I would want to know how long you've been in ther markets to back the validity of the statement.

Jan 31, 2018
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