Comment by JumpCrisscross | Hacker News Reader

Comment by JumpCrisscross | Hacker News Reader

Ah, I think I figured it out. Un-informed retail flow is valuable. When I was an options market maker we paid a sweet premium for a particular retail brokerage’s flow and still made a killing on it. Robinhood.io would appeal to individuals who value smaller commissions over better execution, i.e. those with limited capital or investing experience. So that gives them one side of their revenues.

But that’s not enough - the fixed and variable costs to providing even decent execution are staggering.

I think the second bit, margin lending and API access, might be them selling sheeps’ clothes to the wolves. As a sophisticated trader, it may be of value for me to mix my flow with that of unsophisticated retail traders. It’s an interesting model and a careful balancing act. As a market maker I would keep a close eye on the information content of their trades and cut them off the moment they started looking too sensible. Compounding the problem would be that the informed traders will tend to dominate the un-informed, in terms of volume.

My alternate hypothesis is they're going to offer commission-free trading in a limited pool of symbols - you should be able to get sufficiently reliable retail flow for, say, AAPL to be able to internally cross most orders.

P.S. Not sure using FINRA affiliation to vouch for your security credentials is compliant

Laughing at 'unsophisticated retail traders.'

So, now I'm unsophisticated because I would like to own some individual stocks? You assume the execution is all that matters, but if you are investing in the long-term profitability of a company, then I certainly hope a few hours or even a day doesn't matter. But a $10 commission on a $1000 trade starts you at 1% in the hole.

If 1% puts you in the hole for a long-term trade, you better rethink your strategy.

100% minus 1% is 99%. You thus have less than your principal. I.e. in the hole. It's pretty simple.

Right, in the hole initially. If you don't crawl out of the hole, you're long-term investment failed either way -- and 1% isn't gonna make or break you, unless you are extremely diversified. If you are extremely diversified, you probably won't be using one of these services anyhow -- you'll be putting in lots of funds to a real platform that gives you rates for large sums of cash.

Sorry, didn't mean to come across as condescending.

Think of it this way: if you had to take the other side of a thousand random trades by individuals putting down a thousand dollars and one random trade by an individual putting down a million dollars, which one would you prefer? More to the point, if I gave you a dollar for every percentage point a random thousand-dollar trade outperformed the S&P 500 and every percentage point a random million-dollar trade outperformed the S&P 500, over the long run, which one would you rather take? Assume a liquid stock and so no significant market impact by either trade.

Retail flow is almost always unsophisticated. Decisions are made with a much smaller subset of the information available at any instant compared to active market makers, hedge funds, etc.

"Sophisticated" is a specific finance term[1]; "unsophisticated" isn't a pejorative in this case, it doesn't imply anything other than a lack of experience in securities trading.

[1] http://www.investopedia.com/terms/s/sophisticatedinvestor.as...

could you explain a bit more about the mechanics of buying/selling retail flow? or is there any standard reference for learning more about the details?

We had a contract with a retail brokerage under which we paid them a fixed monthly fee plus a fraction of the flow they sent us in exchange for being their exclusive options market maker. We had to execute the trade at the national best bid and offer (NBBO). We made the difference between the NBBO and whatever we managed to execute at. These are contracts negotiated between broker-dealers, so a relevant attorney would be your best source of information.

Could you go into more detail about the difference between the NBBO and what you were able to execute at?

My understanding is that the NBBO is, by definition, the best executable price. If you're able to execute for a better price then the price you paid was the NBBO.

It would be nice to hear from him how often he executed "inside" NBBO. That's easier to do in spread trades than in simple puts and calls.

Also note, he said he was acting as a MARKET MAKER.

E.g. let's look at where a particular AAPL option closed on Friday:

AAPL131221C00550000 9.65 bid 9.85 ask

Another, bigger difference because it's further in the money:

AAPL131221C00500000 54.15 bid 55.20 ask

Another, bigger difference because it's further out in time:

AAPL150117C00550000 bid 65.50 ask 66.40

The market maker buys at bid, sells at ask. If he can do that thousands of times a day in a thousand different securities, the profits start to add up.

Doing this in options means the market maker needs to be quite nimble, even more than with stocks. This is because he's buying or selling a DERIVATIVE and the UNDERLYING security can change in price quite quickly.

But that's why these guys buy fast computers and why they pay smart people the big bucks to write software for those computers (and to e.g. program FPGAs for high speed trading).

Option bid/ask spread is much wider because 1) notional value is 100 shares as opposed to 1 share of stock, 2) has an additional mysterious value, volatility in the option pricing formula, 3) for OTM options, has volatility simile aka "black swan" properties that elevates the pricing and spread higher.

It's not as easy to make money being a options marketmaker because you have to realize not all of your trades will be someone taking your bid/ask. Even so, you'll have delta-hedge your position with the underlying which is a imperfect hedge that is subject to jump risk. Typically a AAPL options marketmaker is taking orders from traders and has up to couple hundred of these AAPL with long name positions, and they have to balance out the greeks, delta and gamma. They may even have to buy some options themselves to hedge themselves and pay the market price.

Most trades will execute at something near but worse than the instantaneous NBBO.

Let's say the market is 147.05 at 148.30 (I, as the market maker, am willing to buy at 147.05 and sell at 148.30). That's the NBBO. If someone IMs me and says they're willing to buy at 147.10, that moved the market and thus the NBBO. I am required, by law, to report that trade to the consolidated tape.

But if someone IMs me and says they're willing to buy at 147, that's worse than the NBBO. I would then consider lifting at 147 and selling at 147.05. Why would someone buy at worse than the market? Maybe the market was 147 when they put in the order and their computers were slow to catch up. Or maybe they're George Soros placing a multi-billion dollar bet and know that if they put an order into the NYSE it's going to execute at much worse than 147. Either way, I functioned as a market maker by taking their problem and making it mine.

Did you mean to say that the person in the second example is a seller? (147 is cheaper for a buyer than 147.05, the NBBO. You "lift" an ask not a bid).

A few points:

1) If they're FINRA regulated as a brokerage, then it should be enough.

2) Your point on uninformed flow is very very interesting here. I wonder if having a marketmaking group on the other side of a chinese firewall that has flow rights justifies this model by itself.

Does someone like Interactive Brokers has worse execution than a place like E-Trade since their commissions are significantly lower?

My experience with Interactive Brokers (vs etrade, various banks, etc) is that they are the most professional of the online brokerages available to the plebs.

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