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So, we're back to Delta hedging. We're back to realizing that delta-hedging options is something radically different than what you're doing. In our example, I'm trying to manage these Deltas and I'm using the Greeks and Implied Volatility to do that. Now, let’s talk about Implied volatility, without getting too far into it. Implied volatility is a number that I'm going to make money with when it's different from my expected Forecasted Volatility. Remember, as a volatility trader, I have models. On this side, I have models doing a million things to forecast an expected Volatility. I’m not just saying: “Oh, implied volatility is this, but it was lower yesterday. So, this implies it’s going to mean revert back down.”
No, I have sophisticated machines here using mathematical equations, back-testing and factor modeling that looks at, for example, how the yen impacts volatility. How, gold affects oil, which might affect something else, which affects volatility. All of these factors have some correlation and there's a lot of these factors that needs a supercomputer to generate what might give you a valuable forecasted volatility. I then use my forecasted volatility to trade options. So, when you show me an option with a 42 Implied Volatility, I can say: “Oh, that's high. I would sell 42 volatility because my forecast says, it's going to be 40.”
And then when somebody comes in to hit the bid and the bid equals 39 volatility. Well, I'll buy some of those options because my forecast thinks 40 is the right volatility. So, all these different options are being managed by a forecasted volatility. I put it in very simple terms, but essentially that is how it happens. Volatility Trading, or market-making, is a five-dimensional puzzle, but in general, I have this thought of what the Volatility is going to be. And as the option orders come in, my machine is sort of allowing me to say, okay, I'll sell some there, or I'll buy a little bit here.
Okay. So, that’s how volatility traders generally look at the world. That's the concept everybody talks about. And Delta hedging, all this activity that I'm doing, buying and selling stock, is a way to extract profits from this Volatility decision-making process.
I'll give you an example. Assume that you sell an option to me at $1. I pay the dollar premium. Now, let’s assume that the stock is volatile. It trades up and down like crazy for the next four months. But I don't do anything. I just sit there as the stock moves up and down… up and down trading like nuts. And let’s further assume that 5 months from now the stock ends up at the exact spot where we started. Now, the option premium went from $1 when you started to $0 today. Over time it actually went up a lot and came down. But, it’s zero now.
I've lost a dollar on that option, correct? Yes. Okay. Now somebody's going to say: “Yeah, but the volatility was crazy! And you bought the volatility.” Yes, the volatility was crazy. But unless you actually act during the five months, you won’t capture that volatility. You have to actually do something to take that money out of the trade. What you're doing is this Delta hedging that I showed you, which means you have to trade the stock. When you buy options, you trade stock the “right way.” You buy low, sell high and you take little profits along the way. You're hoping that all those little profits add up to more than the dollar premium you paid.
If I'm selling options, I actually have to trade stock the “wrong way.” I sell low and I buy high. And every time I sell low and buy high, I lose a little bit of money. I'm hoping that over time I don't lose more than the premium I took in when I sold the option. That's essentially what's going on. It’s one particular trade, but now you can imagine making thousands of trades and making decisions to trade all the different hedges. The machines help put things in order allowing me to hedge the individual stocks or I can just trade futures against my portfolio of trades. There's a lot of things you can do to manage all of that movement within the guts of your portfolio.
Okay? So, it's important to understand that implied volatility is just a concept. If you buy the option and don't do any delta hedging when the stock goes way up and then way down, then you lose that premium if the option ends at $0. This is how you play the direction of the stock, which is not how Goldman Sachs, Bank of America, or JP Morgan use options. They are playing the volatility. We can go over more of that at another time, because I think it's good for you to see it, feel it, and to understand it.
Now, let’s go deeper into what the market makers focus on. Delta hedging is first. They do a lot of this Delta stock trading. And today it's the machines that are doing it. The machines are automatically in there managing all these positions. It's not like one guy executing millions of trades. Machines are doing the whole thing. Second, there is Implied Volatility, the IV. IV can move up and down. When IV is raised, this means that the premiums on the Options Chain go up. If IV is lowered, then the premiums on the Options Chain go down. Here’s something interesting that people may not know… market makers can control what the Options Chain looks like.
If I'm an options market maker, I control my bids and my offers. How do I do that? Think about using a dial. If I want my bids to go up, then I raise the dial up which raises my bids across the Options Chain. My bids are going up because I'm turning the dial. If I lower the dial, my option offers come down. Okay. So, I can control that. Market makers could control that. To make it easier to understand the next step, let's assume there's only one market maker… Citadel. Citadel sets the price. The next step is where I put all these concepts together to show you how money disappears, or more specifically, how Citadel can make a lot of money without investors seeing them make money.
Here's an example. Let's assume I’m Citadel and you're buying an option. You come into the market in the morning to buy an option. I see you coming. And I know you're going to be an option buyer. Anticipating you, I raise the volatility by simply raising this dial. This raises my bids ahead of your arrival. As a buyer, you have to pay higher and take my higher offers.
You and many others buy the options in the morning and then wait for the option premiums to rise to make a profit. You wait an hour or two, you look at the market and come back. You and maybe 10 other investors come back looking to sell them. After you bought those options, I started slowly moving that dial down anticipating your return. I'm bringing down my prices. Whatever stock you choose is moving around. It becomes very difficult for your eyes to notice me shifting the dial against you. You're not going to be able to see me reducing prices. You're just going to see option premiums. But they are relative prices based off the stock price. You won’t be able to adjust and compare what you paid earlier to what you see now. But those prices are lower, the bids are being lowered by me, Citadel. I'm the puppet master. I'm moving that IV down ahead of your return because I know you are a seller when you come back in.
You bought Call Options in the morning and paid $1.00 for those calls. Let’s say that the market went up a dollar and you thought you were going to make 50 cents. Maybe the Call Options are only $1.40 or $1.38. In your head, you're wondering: “Man, I thought I was going to make more money.” Well, you are short your expectations and you don't understand why. Maybe I lowered the Implied Volatility. If I'm able to see you coming, I can lower it because I suspect that you're going to come in and sell it. I can lower the IV down and bring my bids lower. And then when you walk into the market, I am showing you a lower bid-ask.
That is something that you won't be able to see. You likely won't know to even look at the difference. And sometimes it's not 12 cents. Sometimes it's 5 cents or 4 cents difference. It’s something that you're not going to be able to see by looking at the premiums. But you can see it by looking at the implied Volatility in the mornings. You'd have to look at the Implied Volatility in the mornings and then at the end of the day. You’ll notice how they're moving up and down on the New Options Chain.
You could see that when a buyer comes in, what are the Implied Volatilities doing? The Implied Volatilities go up. And then all of a sudden, after the buyer stops, the market makers drift them back down. They see buyers coming in and they think: “We're going to raise it really high. Then we're going to sell it.” And then they're making money because they start lowering the Implied Volatility the minute that the buyer steps away. Imagine a store constantly raising their prices at peak hours. People would stop coming at that time because they see what’s happening. So, you can't do that in store. But in the options market, it's being done with this Implied Volatility dial and nobody could really see it. It's hard for people to visualize what’s happening.
That’s a clear example of me being a puppet master, moving the options premiums up and down. Then there's a concept called Options Skew. Skew is basically the relationship between Put Options and Call Options. For example, are Put Options high relative to Call Options? How high are they relative to Call Options? If Skew is really high, that means Put Prices are relatively high. So, if I see you coming to the market and you ask: Where can I sell my Puts? I might go into the back room and change the Skew dial. And I, as you're sitting there, I can move the puts back down by turning the Skew dial lower. The Skew dial and Implied Volatility dial are two different ways to change the option premiums you see on the Options Chain.
If the Skew is high, put option are higher versus call options. When Skew is low calls are relatively higher than put options. It doesn't mean that call options are higher in price. It just means that they're relatively higher than the Put options. It’s important because the market makers profit from shifts in skew. Skew is just a number that you can compare to historical numbers and gauge whether it’s high or low. Is it usually like this? Or is it usually like that? If it's usually like this and today it's lower, that means Calls are priced relatively higher today versus the past. This means that there is greater demand for Call options and more selling of Put Options.
Now, Citadel has all of this data from Robinhood through its payment for options order flow partnership. Here's what's really interesting. At OptionsGeek, I've been talking a lot about artificial intelligence. I'm a big believer in artificial intelligence. I understand the power it has to comes up with better answers than humans. In much faster time. And it's been doing this for quite some time. IBM’s AI machine beat World Champion Gary Kasparov in chess years ago, maybe a decade ago. Now it can consistently beat the best chess players in the world. Imagine that. It’s incredible. It's an incredible feat. So artificial intelligence is powerful. It's used by this company, Palantir and sold to companies to better their answers, to questions, to company questions.
AI helps executives get the right answers and commit to the right strategies, whether it's marketing here or marketing over there or don't market after nine o'clock, market between 12pm and 4-5pm, etc. etc. Artificial Intelligence needs data. And through that data, you get the right answers and through the right answers, it translates to profits. So, the more data you have, the better answers you're going to get. I am sure Citadel has an abundance of AI combing through all this data that they're getting from the millions of Robinhood stock and options trades every day.
Over the course of the last three years, it's millions and millions of who knows how many terabytes of data. But it’s a massive amount of data. It’s this data that helps them get the answers they need to profit. Now, what would be the most valuable data for Citadel? I don't know what type of data they get, but great information would be knowing who the counterparty is, meaning do they know Marko is coming into buy, can they know information about Marco's account, specifically, how much money he has in his account. Where does Marko live? With that detailed information AI can figure out a lot. If Marco trades on an AI system for X amount of time, I don't know exactly how long it will take, but I don't think it's that long. The machine is going learn exactly how Marko trades. Exactly how Marko's brain is thinking about trading. Exactly when and how Marko will trade… even before Marko trades.
So, now imagine, this machine is tracking you and learning about your trading decisions. “Ah, Marko just bought this today. Marko is going to sell it within the first eight minutes, 95% of the time. So, I'm going to watch Marko's order. If the stock goes down a little bit after buying some, I know Marko is going to sell it quickly 99% of the time when it hits this level.” Sure enough, it's at that level. And there goes Marko selling that position. Citadel knows this, because the AI is telling them. The AI reads the data, sees the opportunities, and then acts on it in a way that helps drive profits. The more information you give the AI, for example, the more Marko trades, the better it can predict your next move. It gets to a point where the machine will trade before you even trade and it will do exactly what you do before you do it. It's incredible.
Now imagine having that data from millions of millions of users. Let me give you a perfect example. We talk a lot about how the day traders are heavily into options. These days you could see it. You could see the large volumes each day, yet the open interest numbers don’t move up a lot. This means the traders are opening and then closing the trades each day. Let’s use the SPY as an example. There are so many day traders in there, that Citadel’s AI machines have probably figured out that from 9:30am to 10 o'clock every day, 78.4% of the options flow is buying options.
And of those 78% that are buying options, 90% are buying puts. Now, if you had that information, what would you do? You might think to yourself: “Okay. I'm the guy with the dials. So, I'm going to raise the Implied Volatility dial at 9:30am, raising prices. Everybody's going to come into buy like they do every day, and I know that they buy put options X percentage of the time. So, I am also going to raise the Skew dial.” Now, you have taken advantage of what you know through your AI. When everybody comes in to buy the puts, they're getting the double-whammy effect against them. They're going to pay a higher implied volatility, and… and I'm going to skew the premiums higher for them. Both actions effectively raise Put Option Premiums. So, after they buy the puts by 10am, I start reducing the Implied Volatility and the Skew, reduce the skew, which puts pressure on the SPY Put Option Premiums, making it harder for those early buyers to make money, thus giving me an advantage.
When the stock moves down, they're not going to make as much money as they thought they would. And when the stock moves higher, the Put Options will lose more than they expected. I'm effectively deflating their option and making money of that because I sold those options. This might be a lot to take in the first time. I hope I explained it ok. This dial mechanism is an illustration of how Citadel moves the premiums without investors realizing it and how AI helps direct them. Through their relationship with Robinhood, they gather valuable data that is given them the answers they need to profit.