December 24, 2020
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Transcript

Disclaimer:

This podcast is for educational purposes, only options. 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 the video.

 

Felix:

If you were playing poker and you were able to see everybody's cards, could you win? Of course. You see everyone's hand. You know what they're doing. In our example, when Citadel is buying this order flow, they see all the cards. They may not know it's Marco, but when you have millions of people, they have the AI in the data that's telling you that there were 500,000 options bought today in two-day options or in the weekly options.

Then, assume we are at Citadel, we know that of the 500,000 options that were bought in the weekly options, let's call it 425,000 of those options are going to be closed at the end of the day. We know this because we know who the customers are and their tendencies. Customer one, two, three, four, they day trade… customer nine, six, seven, five, they are day traders. So all of this data comes in and we've identified him, him, him, him, him… the AI knows with high confidence that these guys will close out their trades. At all times the machines know the information on who's going to get out. It’s valuable because they can add up the Delta's. Remember, we talked about the deltas. They can add up all the deltas that people are holding to calculate the effect that closing their positions will have on that stock. And then they can get in front of it.

So, if we know Marco and his whole family owns Call Options, and they are day-traders, then we know at some point they have to get out today. Which means they're going to be selling all those calls. Which means we will be buying those calls and our hedge is going to be selling stock. So, as the clock starts ticking towards four o'clock… two o'clock, three, o'clock… guess what? I start having more and more confidence of when the selling is going to happen. There’s a smaller window of time when you're going to get out. 

Why? Because I know you're going to get out. Because I know you're a day trader. Because I know that you and 400,000 other people are holding on for some reason today. And the clock is ticking down to 20 minutes left in the day, 15 minutes. Well, if I know that, and I know that all of you are about to sell to close down all those positions, that means there's going to be, let’s say, 15 million shares of deltas or shares for sale according to the estimates.

If I know this, then why would I wait until you're ready to come into the market? I know you're going to come. I know you're going to be here within the next 15 minutes. You have to be, just because this group of 400,000 independent traders always sells. And so, knowing this information I could start selling 15 million shares. Not all at once. Maybe I sell the first 500,000 shares hard to get a reaction. Sell them hard, 500,000 shares, to move the stock’s bid down… boom, boom, boom. It drops. That scares people. that scares Marco and his buddies. And they're like: “Whoa, what happened there? Maybe we should get out now.” And your buddy says: “No, no, no, no, let's wait.” And then I sell it harder again, because I want to wake you up to sell your calls into me.

Now. The machines may not know who or where you are. But they know there's millions of shares that will need to be sold. So they don't care where you are. They know that they're trying to hit the stock to get the crowd to sell those calls. They know that if they can push the stock lower with that 15 million for sale, the sellers are going to sell their Calls. So they start selling it and they can push it lower until the avalanche of 15 million shares starts coming for sale. In the meantime, the bids are dropping on the calls because the stock is lower and also because I have also moved my IV and Skew dials against this crowd. So, by the time everybody's trying to get out of these positions I have sold my stock and now I am buying my calls back at a lower price from the crowd. But, I already knew how it would play out. I knew that 20 minutes ago. I knew you were going to get out of those positions along with the 400,000 people. And so, I can actually just sell my deltas ahead of all that. I can use the stock, meaning I could use my anticipated Delta hedge to start the push that will get the crowd to follow.

And that's how Citadel can make a significant amount of money. There's a lot of ways with the information they have. And they don't care if Marko wins, in fact, they probably want Marko to win so that you keep trading. Citadel cares about having everybody's position in hand so that they know the bigger picture. And they have good AI to tell them the very high probability trades. The AI finds the situations where there are 15 million shares for sale in the next 20 minutes. Then starts selling stock to get in front of what it is likely to happen. That's pretty incredible. That's how, Citadel, knowing the answers, can make a fortune. And that's why they pay $500 million to Robinhood for that information. $500 million in payment for order flow to see everybody's cards. They're paying that because through AI and through that data, they get the answers to profit. And it's completely legal. They're just using mathematics to figure out what is highly likely, very highly likely to happen. And then they could just push the stocks in the direction that they want. That’s the really interesting part not talked about.

Marko:

Right. Yeah. I mean, as an investor, I'm not really sure how to adjust to all this. So how do I figure this out? How do I not get caught up in this?

Felix:

It's very difficult. You're trading against machines, and so it becomes very difficult. That's part of the reason why I say don't focus so much on the Greeks or Implied volatility. Focus on price. Focus on where you think the stock could go and what price you're paying. And ultimately, if you're right on that price, which is also not very easy to do, it should work out ok. It's only one guess, right? Make your options decisions based on what you're paying in premiums and forget about the games that the market-makers are playing. Focus on what you're paying and where you think the stock is going.

The hedge fund managers, they don't care about all the little games these guys are playing. They don't care. “If you want to steal 3 cents from me, fine, I'm going to make $5 on this trade.” They understand that it’s part of the game. And if you want to play this game of hide-n-go seek and try to capture pennies, that's great. Good luck. Go play that game. You know, my boss used to say, it's very funny. I mentioned “volatility” once to him. He looked at me asked: “You ever been to the Hamptons? I said: “Yeah.” And then he asks: “How many volatility traders you see have Hamptons houses on the beach?” And I said: “I don't think I've ever been in a Hamptons house on the beach, but not many?” He goes: “Yeah, you're not going to find many. Maybe one, Ken Griffin.” He’s right, maybe a couple over the last 20 years, because of the rise of the mathematicians like Jim Simons. But most of the times, it's the big leverage hitting hedge fund guys.

They want to buy CDS on the housing market because they think that they could make $15 billion on that trade. CDS are Put Options on Bonds. So, his point was, those that have Hamptons beach houses are mainly the investment managers that buy options for a dollar because they want the huge leverage. 

Marko:

That reminds me of the story that you told in an interview. Where you told your boss that some option was expensive and then your boss told you: “If I think it’s going there, I don't care about it being expensive or not expensive.”

Felix:

Yeah. It's my first day of the job. He almost fired me. I will never forget that. I was trying to prove my worth on the first day. I’m trying to show him: “Hey, I'm smart. I know what I'm doing.” And he says, buy 5,000 of these Call options for $1.10. Even though they were a dollar on the screen, he said, “I'll pay a $1.10.” The bid-ask was $0.90 bid at $1.00. I started doing all this research on the price, trying to look at all these numbers and find some theoretical value of that option. I waste like five minutes and turn around to say: “Hey, you know, this option is really worth 93 cents.”

So, he looks stunned. He asked: “You didn't buy them yet?” I said: “No, I was trying to figure it out. I didn't want to pay too much.” He almost lost it, but I could tell, it was the first day and he didn't want to scare me. So, he goes: “Can you do me a favor? Can you just buy those options? Like right now?” I get in motion to pay a $1.10, but tell him: “They're not really worth it.” And he goes: “BUY THEM!!” 

I went and did a good job, paying only $1.00 and saving him 10 cents on 5,000 Call options. That saved them $50,000. But he says: “I don't understand how volatility traders think. I don't know how you guys make money trading for pennies.” And I said: “Well, we make money from the Implied Volatility being too high or low. From you overpaying, like you were about to pay a $1.10.” He responded: “Yeah. But I think that $1.10 option has a chance to get to $5 or $6. How would you make money if the option jumps quickly like that?” I had to admit that I wouldn’t: “I'm not likely to, in fact, I'm going to get killed.” He then just shook his head. After 30 seconds, he turned back around and said: “Don't ever think like that again here. And if you do, I'm going to kick you out.”

You know, it was an eye-opening moment. And I just thought… don't ever talk about what I think is “cheap” or “expensive” from a volatility perspective, because it's two completely different ways of thinking. “Cheap” and “Expensive” is something that is not really understood in the options world outside of the volatility trader’s perspective. An option might be very expensive to a volatility trader, but it might be super cheap to a directional person. And so that's why you need a different education and a different learning process to understand how to think like the Top Hedge Fund managers.

I can teach Volatility Trading and more than happy to do that for people on Wall Street, but that's because their job warrants it. They constantly use the Greeks and implied volatility. That's what their job entails. But for the average investor, they have no business on that side of the fence. Leave it to those guys. Those are mathematicians. Those are engineers. Those are scientists, and that's what they're doing. I happen to have a math background from Wharton. I was sitting there trading Volatility, sitting next to some brilliant minds, wicked smart. They were very good at that game. But if you stick them into a directional game where they're not using Implied Volatility or the Greeks, then it's a different game and it's played in a much different way.

Marko:

Interesting. All right, my man.

Felix:

Yeah. I think that should clear up how Citadel thinks about payment for order flow, and how they make money. Citadel is paying Robinhood $500 million a year or more. They have to make that money back somehow with profits. It starts with bid offer. For example, you take the offer, and sell options on the bid. They make that bid offer spread. But sometimes they have to take down positions. Citadel has a massive book of options positions. They do the Delta hedging all day to manage the risk. Sometimes that simply means they trade the S&P futures instead of each individual stocks. 

Citadel’s book is so massive the likely have hedging program. Maybe every $20 million of exposure the computer goes to buy or sell some futures to offset the risk, to get the book neutral. They don't really care about buying 10 shares of anything. They don't care about that. A hundred shares of IBM, or, short two shares of Apple. They don't care. They aggregate everything together. The computer calculates Citadel’s risk and then trades futures against it. Then within the book, there is obviously a lot of analysis using the Greeks, the shifts in the dials we talked about, and risk managers spotting areas where there's too much risk. That's likely how it's being managed at a higher level. There's a lot of different ways, but that's probably a lot of what's going on. 

To work at Citadel, you must be very smart. They take only the best. They take people who are mathematicians, who are programmers, they need the scientist type that's going to make sure the AI works and continues to develop. If the AI can give you the answers, it's worth a fortune. And obviously, their payment for order flow is $500 million, so, they're probably making billions of dollars off of this arrangement. Probably most of Citadel’s money is made off of Robinhood’s flow, and their other relationships with E-Trade and TD Ameritrade.

Marko:

Wow. Makes sense. 

Felix:

Makes sense. Yes, it makes sense. If you get to see all the cards from all of the people trading, you can push the markets around and make a lot of money.

Marko:

Well, thank you so much. I mean, that clears up a lot of stuff, especially when I'm looking at the board now, and when I'm looking at the New Options Chain, now everything's going to make much more sense. Everything’s going to add up.

Felix:

And one thing on the options chain. The three-month sentiment that’s skew. Underneath that is one-month Implied Volatility. So, you could see them move in the morning. It might be up in the morning and then by the end of the day, you’ll see it move back. Again, that's the market-makers moving the dials up or down to help them profit. So, you got to be careful. You can never beat the machine. So just flying off the seat of your pants might hurt you over the long run. And be careful trading in the mornings.

Marko:

So, one more thought I have, that's why you stress the importance of trying to get a good entry price.

Felix:

Yes. In Winning Picks Premium, I try to prevent people from buying so quickly in the morning because people set market orders and the pricing will work against you. Look, if you give the market makers and Citadel carte blanche with your options order on the open, they will open the market up as high as they can and execute your order on the offer. And then a few minutes later, it’s back down to where it should be and you lost money. So, I ask Members to avoid market orders on the open. You're giving the market makers a license to steal from you. But once the market opens for a few minutes, it becomes harder to move things around so fast. Besides Citadel, there's a lot of other people that are making markets and trying to profit. So that keep things in a range once the markets open after that first print. 

Marko:

And I mean, they're also fighting with each other in a sense, right?

Felix:

Yes. There’s competition to take down that flow. I believe there’s 13-15 options exchanges out there competing for the orders. Citadel trades on the Miami Exchange. They don't have to trade there. So, I think it’s interesting to see where things trade and why. All of a sudden, the Miami exchange trades a significant amount of the total equity options. Nobody's heard of Miami exchange. But look… Citadel's an owner or part owner of the Miami Exchange. This may be allowing them to make more money. It may allow them to get their hedge faster than anyone else. There’s a rule that the customer order has to be flashed to everybody before the handler could trade in the stock. With limit orders, this can give Citadel a significant advantage due to the latency of the order reaching the rest of the world. We are talking milliseconds, which gives them enough time to get in front of the line to trade stock. If Citadel is sending orders to the Miami Exchange then I would think they are receiving an advantage. I don't know if what I laid out is the real reason, but it seems to me that they are getting some advantage. I believe that's the case. 

Marko:

Well, thank you. This was a great session. I would encourage everyone who's watching to comment down below. If you have any questions we're doing another one of these next week, for sure. So, thank you Felix, it was awesome. Always great to learn. 

Felix:

Definitely.


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Find Your Next Idea


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