December 24, 2020
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Transcript

Felix:

This podcast is for educational purposes, only. OptionsGeek, LLC is not a broker dealer OptionsGeek, LLC, Felix Frey and Marko Rojnica are not registered investment advisors. Keep in mind options involve substantial risk and are not suitable for everyone. Please consult your own investment advisor before doing any trading. Make sure you read the full disclaimer at the end of this episode.

Felix:

Marko, hey, how are you?

Marko:

Good. Good. I'm glad I got a hold of you because we've been talking about Robinhood, Citadel and payment for order flow on the podcast for a few episodes. I urged you to tell me more about this topic because I was interested in the behind the scenes at Robinhood. Like, what really goes on? You briefly went over it and I'm pretty shocked about what I heard. So, I’m excited to get a more in-depth explanation. And to everybody who's watching this, I recommend that you sit back, grab some coffee and enjoy the ride because this is something amazing and something you've probably never heard before. The behind-the-scenes activity is certainly at the back of most of our minds… AI bots, how everything works, … when we trade, who buys our stuff? et cetera, et cetera. So, Felix, let us know all about it.

Felix:

Sure, sure. So, yeah, at the end of the day, most investor’s questions are: Who's actually buying my options order? Who's taking the other side of the options order? Am I getting cheated somehow? What's actually happening behind the scenes at Robinhood? How's it all working?

I think it's important to understand what's actually happening with your options order so you understand how others are making money off of your options order, and to know who the players are. There was an article, I think last week, that said Robinhood was fined by the SEC. I believe they got in trouble for not informing their users how Robinhood was getting paid from their customer’s options order flow, and who they were selling their options order flow to. There are two main players in the options payment for order flow and … let's call it three: Citadel, Virtu, and Two Sigma. Those names have popped up over the last few years as the largest and Robinhood takes payment from all of them.

Felix:

Robinhood takes their customer’s orders, millions of options orders, and sells them to these three parties. Now they're not the only ones doing this. This is a practice also used by E-Trade, TD Ameritrade, places that don't have their own trading. They're simply a website or app that has an options chain or a tool that allows you to buy stock or options, but that's all it is. And then there’s this backend that keeps track of your account and holds the money. It's conceptually a fairly simple business. Where it becomes complicated is how they execute, the regulations that are involved. And, obviously, having the capital to meet any requirements as a broker-dealer.

Felix:

Essentially, they are the middle-man. These brokerages spend most of their money on advertising to get investors into their fold, into their broker-dealer, to house investor money in their broker dealer, and to get investors trading through them. That's where most of the money goes… marketing. You see TD Ameritrade sponsoring CNBC. They spend marketing dollars. People see the ads and then go to TD Ameritrade to open an account. So that's one side of the fence. The other side is behind-the-scenes, where it's this bottomless pit of not knowing where your options trade goes? All of a sudden, your options trade report pops up in your account and everything works. So again, Robinhood or TD Ameritrade takes account of your balances and your positions, but the actual options trading is handed off to let's just say… Citadel.

Felix:

I think Citadel makes up about 60% of this order flow coming out of Robinhood. They are the biggest player in payment for order flow. Citadel is paying a small fortune to Robinhood each year to get access to these trades, execute them, and to obtain valuable trading information. On stock orders, I believe I just saw it on the internet, they pay about 17 cents per share. On options, I don't know the exact amount, but it's probably 30 to 50 cents per option contract. 

So, for this discussion, we're just going to assume that Citadel is the only player paying for order flow. There's obviously more, but let's just talk about Citadel and Robinhood. And then the other characters in this story are the millions of people that are actually trading.

Felix:

Now, when you trade an option, you can think about it as a piece of paper. It's not a stock. It's another type of security. It's a piece of paper. And when you trade that piece of paper with someone, the person you are trading against happens to ultimately be Citadel. So, if you trade at Robinhood, they funnel your options order to Citadel, who trades the other side. Citadel reports back to Robinhood the price your options order was executed at. The accounting is done at Robinhood, and then you get notified.

Again, this piece of paper, your options order, is just a contract that says, I get to buy… Let's call it Apple, let's say the $135 Calls.

Felix:

That's going to be our option for one month. Assume the $135 Calls cost a dollar. We buy that option, Robinhood sends it out, and Citadel sells us that contract. Assume we buy 10 contracts, for a thousand dollars. Citadel sells those contracts so they take our premium. Now it's important to understand that we just traded a contract, like this white piece of paper that says, “I buy 10 Apple $135 Calls.” When Citadel trades that contract with us, they actually have to do something on their end. They have to trade Apple stock against that piece of paper to hedge.

Felix:

If you bought the calls, they have to buy stock. If you sold the calls, they have to do something. If you buy puts, they have to do something. If you sell puts, they have to do something. It's important to understand what they have to do. 

Here’s an easy way to remember what action they will take. If you're buying calls, you're bullish. Right? When you buy calls, assume it’s written on this white piece of paper, Citadel sells that piece of paper. At the same time, they buy stock. So, you're bullish and you buy calls. They have to buy stock. If you are selling calls, they're buying the options back from you and then they have to sell stock. 
Okay? You buy call options, Citadel buys stock. You sell call options, Citadel sells stock. Now, if you buy put options, let’s say the $130 Puts in Apple, what does Citadel have to do? Well, puts means you think that the stock is going to go down. So, when they trade this contract with you, they're going to have to sell stock, or short sell the stock if they don't own it. If you’re going to sell put options, Citadel has to buy stock. 

Felix:

Okay. Now the question becomes, how much stock do they buy? Right? Not every option is the same. Every option has what's called a Delta. As a side note, there's a lot of talk in the options industry about the Greeks and implied volatility. But as you’ll see in a few minutes, most of that stuff is being used by the market makers, traders at the investment banks, and only a few hedge fund traders. In fact, only a very small percentage of hedge funds trade options to profit from the Greeks and Implied Volatility. 

Back to the question, how much stock do they have to buy? Each option is different. Each option carries its own Delta. What is Delta? Delta is simply going to be a percentage of what the contract represents in stock. So, we assumed that we bought 10 options contracts. how many shares does 10 options contracts represent? 10 times the 100 multiplier is a thousand shares. If you buy a 10 lot of Apple calls, then it gives you the right to buy a thousand shares of Apple at a certain price.

Felix:

We're not going to get too much into the Greeks, but if the Delta on the Call option you’re buying is 35%, then as the Citadel trader, I have to buy 35% of a thousand shares, or 350 shares. I don’t need to buy a thousand shares, just 350 shares for my hedge against selling you those Calls. 

Now let's assume Apple goes way up. Some news has just taken the stock a lot higher. When you go to sell those Call options, that option might have a different Delta.

Felix:

For example, that Delta might be 80%. So when you come out to sell those calls, I'm going to buy those calls. But now I have to actually sell 80% of a thousand shares, which is 800 shares. Notice that there's a difference in the amount of shares I need to trade now versus when you first bought the Call Options. I only had to buy 350 shares when you bought them. Now, when you're selling them, I have to sell 800 shares because the Delta of the option changed. There’s a difference of 450 shares. What happen? Well, as the stock moved up, I was actively buying stock according to my delta. This is what Citadel does every day. 

All you do is buy the Call Options and let’s say you went to the beach for the day. 

Not me. I'm over there trading stock all day. I sold you the calls and I bought 350 shares. Now the stock starts climbing and going up and going up. My Deltas change. My Delta goes from 30% to 40% to 50% to 60% to 70%. Every time the Deltas go up by 10%, I have to buy shares by another hundred shares of stock. By the end of the day, you come back from the beach and you say, “Oh, Apple is up. Look at that. I have this piece of paper. And I spent a dollar. Now it's $4, $5. Okay. Now I'm going to use my Robinhood app and I'm going to sell those calls.” You press Sell and Robinhood sends the order to Citadel to execute. Simple for you. Meanwhile, me being at Citadel, I’ve been trading all day. I've been buying shares according to my Delta as the stock trades higher. When you decide to sell it, the Call Options have an 80% Delta. This means I have to sell 800 shares. 

Now imagine there's millions of people doing this. Millions of people are trading one contract, 10 contracts, a hundred contracts. But the big investors trading 10,000 to 20,000 options contracts execute through the investment banks. So, when you see unusual options activity, when you see someone buying 10,000 calls, the reason big investors don't go to TD Ameritrade or E-Trade is because they want an investment bank to commit capital and stop them out of the hedging risk that comes with large options trades. 

For example, a big investor says: “Hey, I want to buy 20,000 of these Apple calls for a dollar.” 20,000 options represent 2,000,000 shares. Assume it's a 30 Delta, which means I have to buy 2,000,000 times 30% delta, or 600,000 shares of Apple. Now, Apple is a very thick stock and you can buy a lot of stock without pushing it around too much, but some names are not so liquid. And if I miss those 600,000 shares at the price I expected, then I start losing money because I'm making the decision to sell those 20,000 options to the customer based on where I can actually get the stock.

Felix:

So, as the size of the options trade increases to 20,000, my offer might not be $1.00. It might be closer to $1.20, because by the time I buy 600,000 shares of Apple, the stock might be up 50 to 70 cents. If the stock is up 70 cents, how much is the option going to be up? Well, on a 30 Delta, it should only be up about 30% of that move, or around 21 cents. So, I am pricing the Call Options according to where I think I'm going to be able to buy the stock. This is what happens every day at Bank of America or at Goldman Sachs when a big shark comes in to trade. As you can imagine, the risks in some of these trades are significant.

Citadel would much rather trade options against the smaller retail investor at Robinhood because these hedging risks with stock are manageable. It's important to understand the mechanics happening here to see how Citadel makes their money trading. But also, to better understand the less noticeable ways Citadel can make a lot of money off the retail investor’s options order flow.

Felix:

I don't have any proof that Citadel uses these methods, but I can see very specific actions taking place in the mornings and in the afternoons. I'm going to explain it to you, but I can't get there until you understand these mechanics. 

So, the important points are that there's this hedge. I am a person that is using my Deltas to make these stock trades. And the reason why I'm using these Deltas is because I'm playing the math. I am actually playing the Greeks and I'm using implied volatility to profit with it. This is what it means to be a volatility trader. 

Marko:

Okay, okay. That's how these guys make money… that's the difference. And what this education teaches everybody is how to make money that way or at least understand how they do it. So, I mean, for me, it's pretty much impossible to do what they do, right?

Felix:

It's not impossible. But, you certainly can’t learn how to be a volatility trader in a week or two. I'm simply showing you how the market makers think and how they make their money. It's very different from what we're doing here at OptionsGeek and what millions of investors are trying to do. At OptionsGeek, I’m showing you what the top investors in the world do. I hope you can see that the top investors in the world buy 20,000 options and then say:  “I'm going to the beach. I'm going to the Hamptons. It's a two-month option and I'll see you later.” Right? They don't care about the deltas changing up and down every day. It’s not how they make their money.

Felix:

They’re watching the stock go up, down, and when it gets to a certain level, they're going to sell that option to take profits. Meanwhile, in those two months, I'm managing that position every day. I'm buying stock here. I'm selling it there. I'm doing something against it. I'm trading in another option to reduce my risk. There's a lot going on every day. 

The big hedge fund guy, he just bought 50,000 call options and then went to his beach house for the summer. At the end of the summer, he came back and he said: “Oh, I bought it for a dollar. It's eight. Okay. Sell it.” 

Marko:

So, you sat on both of these sides, the investment bank and the hedge fund, right?

Felix:

I sat on both sides. And that's why I know the difference between each side. I understand the nuances. And that experience is what the OptionsGeek education offers. I've pinpointed the fact that people don't understand how to actually buy options in a way that they can understand and explain to someone else. Think about this. There’s a million to 5 million people trading options at Robinhood. I bet that I could ask those 5 million people two questions: How do you know when to buy options? And two, how do you know which strike to buy? And explain it to me, really explain it because it's not good enough to just say: “Oh, because someone told me to do this.” 

No, I want you to explain why that's the best option for you. 5 million people. I would bet that, unless they learned it at OptionsGeek, 5 million people… 5 million out of 5 million couldn’t explain it. They might pick the right one, but it doesn't mean that they understand exactly why that is the right one. That's how big and incredible I think this problem is. It's such a huge problem because if you don’t understand how to choose the right option, it's a probability game, you're just kind of guessing at which one is right. And ultimately that's why people lose. So, at OptionsGeek, we're trying to fix that.

Continue with Part 2

Watch Next

PART 2

PART 3

Find Your Next Idea


Transcript

Felix:

This podcast is for educational purposes, only. OptionsGeek, LLC is not a broker dealer OptionsGeek, LLC, Felix Frey and Marko Rojnica are not registered investment advisors. Keep in mind options involve substantial risk and are not suitable for everyone. Please consult your own investment advisor before doing any trading. Make sure you read the full disclaimer at the end of this episode.

Felix:

Marko, hey, how are you?

Marko:

Good. Good. I'm glad I got a hold of you because we've been talking about Robinhood, Citadel and payment for order flow on the podcast for a few episodes. I urged you to tell me more about this topic because I was interested in the behind the scenes at Robinhood. Like, what really goes on? You briefly went over it and I'm pretty shocked about what I heard. So, I’m excited to get a more in-depth explanation. And to everybody who's watching this, I recommend that you sit back, grab some coffee and enjoy the ride because this is something amazing and something you've probably never heard before. The behind-the-scenes activity is certainly at the back of most of our minds… AI bots, how everything works, … when we trade, who buys our stuff? et cetera, et cetera. So, Felix, let us know all about it.

Felix:

Sure, sure. So, yeah, at the end of the day, most investor’s questions are: Who's actually buying my options order? Who's taking the other side of the options order? Am I getting cheated somehow? What's actually happening behind the scenes at Robinhood? How's it all working?

I think it's important to understand what's actually happening with your options order so you understand how others are making money off of your options order, and to know who the players are. There was an article, I think last week, that said Robinhood was fined by the SEC. I believe they got in trouble for not informing their users how Robinhood was getting paid from their customer’s options order flow, and who they were selling their options order flow to. There are two main players in the options payment for order flow and … let's call it three: Citadel, Virtu, and Two Sigma. Those names have popped up over the last few years as the largest and Robinhood takes payment from all of them.

Felix:

Robinhood takes their customer’s orders, millions of options orders, and sells them to these three parties. Now they're not the only ones doing this. This is a practice also used by E-Trade, TD Ameritrade, places that don't have their own trading. They're simply a website or app that has an options chain or a tool that allows you to buy stock or options, but that's all it is. And then there’s this backend that keeps track of your account and holds the money. It's conceptually a fairly simple business. Where it becomes complicated is how they execute, the regulations that are involved. And, obviously, having the capital to meet any requirements as a broker-dealer.

Felix:

Essentially, they are the middle-man. These brokerages spend most of their money on advertising to get investors into their fold, into their broker-dealer, to house investor money in their broker dealer, and to get investors trading through them. That's where most of the money goes… marketing. You see TD Ameritrade sponsoring CNBC. They spend marketing dollars. People see the ads and then go to TD Ameritrade to open an account. So that's one side of the fence. The other side is behind-the-scenes, where it's this bottomless pit of not knowing where your options trade goes? All of a sudden, your options trade report pops up in your account and everything works. So again, Robinhood or TD Ameritrade takes account of your balances and your positions, but the actual options trading is handed off to let's just say… Citadel.

Felix:

I think Citadel makes up about 60% of this order flow coming out of Robinhood. They are the biggest player in payment for order flow. Citadel is paying a small fortune to Robinhood each year to get access to these trades, execute them, and to obtain valuable trading information. On stock orders, I believe I just saw it on the internet, they pay about 17 cents per share. On options, I don't know the exact amount, but it's probably 30 to 50 cents per option contract. 

So, for this discussion, we're just going to assume that Citadel is the only player paying for order flow. There's obviously more, but let's just talk about Citadel and Robinhood. And then the other characters in this story are the millions of people that are actually trading.

Felix:

Now, when you trade an option, you can think about it as a piece of paper. It's not a stock. It's another type of security. It's a piece of paper. And when you trade that piece of paper with someone, the person you are trading against happens to ultimately be Citadel. So, if you trade at Robinhood, they funnel your options order to Citadel, who trades the other side. Citadel reports back to Robinhood the price your options order was executed at. The accounting is done at Robinhood, and then you get notified.

Again, this piece of paper, your options order, is just a contract that says, I get to buy… Let's call it Apple, let's say the $135 Calls.

Felix:

That's going to be our option for one month. Assume the $135 Calls cost a dollar. We buy that option, Robinhood sends it out, and Citadel sells us that contract. Assume we buy 10 contracts, for a thousand dollars. Citadel sells those contracts so they take our premium. Now it's important to understand that we just traded a contract, like this white piece of paper that says, “I buy 10 Apple $135 Calls.” When Citadel trades that contract with us, they actually have to do something on their end. They have to trade Apple stock against that piece of paper to hedge.

Felix:

If you bought the calls, they have to buy stock. If you sold the calls, they have to do something. If you buy puts, they have to do something. If you sell puts, they have to do something. It's important to understand what they have to do. 

Here’s an easy way to remember what action they will take. If you're buying calls, you're bullish. Right? When you buy calls, assume it’s written on this white piece of paper, Citadel sells that piece of paper. At the same time, they buy stock. So, you're bullish and you buy calls. They have to buy stock. If you are selling calls, they're buying the options back from you and then they have to sell stock. 
Okay? You buy call options, Citadel buys stock. You sell call options, Citadel sells stock. Now, if you buy put options, let’s say the $130 Puts in Apple, what does Citadel have to do? Well, puts means you think that the stock is going to go down. So, when they trade this contract with you, they're going to have to sell stock, or short sell the stock if they don't own it. If you’re going to sell put options, Citadel has to buy stock. 

Felix:

Okay. Now the question becomes, how much stock do they buy? Right? Not every option is the same. Every option has what's called a Delta. As a side note, there's a lot of talk in the options industry about the Greeks and implied volatility. But as you’ll see in a few minutes, most of that stuff is being used by the market makers, traders at the investment banks, and only a few hedge fund traders. In fact, only a very small percentage of hedge funds trade options to profit from the Greeks and Implied Volatility. 

Back to the question, how much stock do they have to buy? Each option is different. Each option carries its own Delta. What is Delta? Delta is simply going to be a percentage of what the contract represents in stock. So, we assumed that we bought 10 options contracts. how many shares does 10 options contracts represent? 10 times the 100 multiplier is a thousand shares. If you buy a 10 lot of Apple calls, then it gives you the right to buy a thousand shares of Apple at a certain price.

Felix:

We're not going to get too much into the Greeks, but if the Delta on the Call option you’re buying is 35%, then as the Citadel trader, I have to buy 35% of a thousand shares, or 350 shares. I don’t need to buy a thousand shares, just 350 shares for my hedge against selling you those Calls. 

Now let's assume Apple goes way up. Some news has just taken the stock a lot higher. When you go to sell those Call options, that option might have a different Delta.

Felix:

For example, that Delta might be 80%. So when you come out to sell those calls, I'm going to buy those calls. But now I have to actually sell 80% of a thousand shares, which is 800 shares. Notice that there's a difference in the amount of shares I need to trade now versus when you first bought the Call Options. I only had to buy 350 shares when you bought them. Now, when you're selling them, I have to sell 800 shares because the Delta of the option changed. There’s a difference of 450 shares. What happen? Well, as the stock moved up, I was actively buying stock according to my delta. This is what Citadel does every day. 

All you do is buy the Call Options and let’s say you went to the beach for the day. 

Not me. I'm over there trading stock all day. I sold you the calls and I bought 350 shares. Now the stock starts climbing and going up and going up. My Deltas change. My Delta goes from 30% to 40% to 50% to 60% to 70%. Every time the Deltas go up by 10%, I have to buy shares by another hundred shares of stock. By the end of the day, you come back from the beach and you say, “Oh, Apple is up. Look at that. I have this piece of paper. And I spent a dollar. Now it's $4, $5. Okay. Now I'm going to use my Robinhood app and I'm going to sell those calls.” You press Sell and Robinhood sends the order to Citadel to execute. Simple for you. Meanwhile, me being at Citadel, I’ve been trading all day. I've been buying shares according to my Delta as the stock trades higher. When you decide to sell it, the Call Options have an 80% Delta. This means I have to sell 800 shares. 

Now imagine there's millions of people doing this. Millions of people are trading one contract, 10 contracts, a hundred contracts. But the big investors trading 10,000 to 20,000 options contracts execute through the investment banks. So, when you see unusual options activity, when you see someone buying 10,000 calls, the reason big investors don't go to TD Ameritrade or E-Trade is because they want an investment bank to commit capital and stop them out of the hedging risk that comes with large options trades. 

For example, a big investor says: “Hey, I want to buy 20,000 of these Apple calls for a dollar.” 20,000 options represent 2,000,000 shares. Assume it's a 30 Delta, which means I have to buy 2,000,000 times 30% delta, or 600,000 shares of Apple. Now, Apple is a very thick stock and you can buy a lot of stock without pushing it around too much, but some names are not so liquid. And if I miss those 600,000 shares at the price I expected, then I start losing money because I'm making the decision to sell those 20,000 options to the customer based on where I can actually get the stock.

Felix:

So, as the size of the options trade increases to 20,000, my offer might not be $1.00. It might be closer to $1.20, because by the time I buy 600,000 shares of Apple, the stock might be up 50 to 70 cents. If the stock is up 70 cents, how much is the option going to be up? Well, on a 30 Delta, it should only be up about 30% of that move, or around 21 cents. So, I am pricing the Call Options according to where I think I'm going to be able to buy the stock. This is what happens every day at Bank of America or at Goldman Sachs when a big shark comes in to trade. As you can imagine, the risks in some of these trades are significant.

Citadel would much rather trade options against the smaller retail investor at Robinhood because these hedging risks with stock are manageable. It's important to understand the mechanics happening here to see how Citadel makes their money trading. But also, to better understand the less noticeable ways Citadel can make a lot of money off the retail investor’s options order flow.

Felix:

I don't have any proof that Citadel uses these methods, but I can see very specific actions taking place in the mornings and in the afternoons. I'm going to explain it to you, but I can't get there until you understand these mechanics. 

So, the important points are that there's this hedge. I am a person that is using my Deltas to make these stock trades. And the reason why I'm using these Deltas is because I'm playing the math. I am actually playing the Greeks and I'm using implied volatility to profit with it. This is what it means to be a volatility trader. 

Marko:

Okay, okay. That's how these guys make money… that's the difference. And what this education teaches everybody is how to make money that way or at least understand how they do it. So, I mean, for me, it's pretty much impossible to do what they do, right?

Felix:

It's not impossible. But, you certainly can’t learn how to be a volatility trader in a week or two. I'm simply showing you how the market makers think and how they make their money. It's very different from what we're doing here at OptionsGeek and what millions of investors are trying to do. At OptionsGeek, I’m showing you what the top investors in the world do. I hope you can see that the top investors in the world buy 20,000 options and then say:  “I'm going to the beach. I'm going to the Hamptons. It's a two-month option and I'll see you later.” Right? They don't care about the deltas changing up and down every day. It’s not how they make their money.

Felix:

They’re watching the stock go up, down, and when it gets to a certain level, they're going to sell that option to take profits. Meanwhile, in those two months, I'm managing that position every day. I'm buying stock here. I'm selling it there. I'm doing something against it. I'm trading in another option to reduce my risk. There's a lot going on every day. 

The big hedge fund guy, he just bought 50,000 call options and then went to his beach house for the summer. At the end of the summer, he came back and he said: “Oh, I bought it for a dollar. It's eight. Okay. Sell it.” 

Marko:

So, you sat on both of these sides, the investment bank and the hedge fund, right?

Felix:

I sat on both sides. And that's why I know the difference between each side. I understand the nuances. And that experience is what the OptionsGeek education offers. I've pinpointed the fact that people don't understand how to actually buy options in a way that they can understand and explain to someone else. Think about this. There’s a million to 5 million people trading options at Robinhood. I bet that I could ask those 5 million people two questions: How do you know when to buy options? And two, how do you know which strike to buy? And explain it to me, really explain it because it's not good enough to just say: “Oh, because someone told me to do this.” 

No, I want you to explain why that's the best option for you. 5 million people. I would bet that, unless they learned it at OptionsGeek, 5 million people… 5 million out of 5 million couldn’t explain it. They might pick the right one, but it doesn't mean that they understand exactly why that is the right one. That's how big and incredible I think this problem is. It's such a huge problem because if you don’t understand how to choose the right option, it's a probability game, you're just kind of guessing at which one is right. And ultimately that's why people lose. So, at OptionsGeek, we're trying to fix that.

Continue with Part 2