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!
Well whatever they can do they certainly aren’t making enough money to do it.
I think there's some subjectivity with these regulations. Based on some conversations I've had with traders, there very much still is a necessity to take on prop risk and to manage an inventory.
However, the distinction they made was one of intent: in the yester-years being exposed to speculative risk was as much the intent of prop traders as handling client flows - one could argue that intent was more heavysided towards risk than flows. The idea being flows sort of gave exposure and market colour to be able to then make specific plays.
Nowadays, that ratio is very heavily flows based but there is still some necessary risk taking in the form of being say "unintentionally" exposed to some greek here or there. The intention however is to service flows with any inventory plays being a side effect of managing the risks from that primary activity. So inventory plays aren't so much a motive as they are a colloray to the day-to-day.
@princepieman thanks for the response, that's very helpful.
So I completely get that the primary objective is to service flows, but essentially in the process traders will always take a view based on speculation though right?
As you say you will always be exposed to a Greek here and there, but a traders choice over what Greek they have residual risk to is completely down to their speculative view surely isn't it*
Is their objective even to perfectly hedge or can they do what they want so long as
In effect, yes.
As long as traders stay within appropriate risk limits and their main "activity" remains servicing flows, they have free reign to how they choose to manage their risk (whether through speculative inventory plays or otherwise).
Got it, thank you
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