How Hedge Funds Trade Options, 3 Things You Should Know

At the hedge fund level, options’ trading is about correlating the drift in market volatility with the magnitude of theta decay. At the retail level, the story is always, “I follow the charts very closely then predict the market. Still no success. What should I do”? The answer is simple, how can you predict, a non-linear component like volatility. This is why trading options, based on a chart pattern is stressful and leads to loss of capital. This phenomenon applies to both option buyers and sellers. In today’s article, we shall look at the things that hedge funds do differently.

Trading Without Cognitive Bias

A cognitive bias is an error in thinking. It impacts the decisions that traders make by a huge margin. Some of these errors take place because traders are often driven by memory or historical charts. Look at it this way, I tell you since it had rained heavily in Mumbai on 10th July 2018, so it will rain heavily again on 10th July 2019. This is cognitive bias. So what is the solution? To overcome this challenge, we use the covariance between theta and vega during the live market. The way we do it is simple, we connect our trading software to a live data feed and extract the information during live market hours. The idea is to trade alongside the market maker.

Market Makers VS Volatility Skew

Last Monday on 16th December, Nifty future slipped till 12074, after registering a high of 12152 in the morning. If you look at the chart now, it will tell you that the fall was an opportunity to go long, but it is too late now. The market has climbed 230 points from there and has hit 12300 approx. The 12200 weekly Call options where the market makers were active made a high of Rs62 and closed @ 59 from our entry price of Rs12.25. Here again, the question is what will happen tomorrow? So how do we figure this? Hedge funds use technology to extract the IV drift during live markets, they never predict. This is where things get interesting; market analysts work more with the volatility skew. There is a big difference between the two. We don’t use the volatility skew because it has a bias, we prefer the IV drift. We use the 3D Delta software, to check what the market makers are doing between 9:15 am and 3:30 pm. Together with the software, we use live data feed to find the zones where the IV drift and the covariance factors match the requirements.

Trade Execution

Remaining calm is extremely essential while trading. However, staying calm is extremely difficult during highly volatile markets, you are always thinking, “Where should I enter? Will my stop get triggered?”. Thus we use a function called relative volatility which is a mechanism used in the chemical industry. Relative volatility measures the vapor pressures of two or more components in a liquid mixture of chemicals. This metric is widely used to separate the more volatile components from the less volatile components in a mixture. In our case, we want to identify option strikes that display unnatural characteristics in IV compared to others due to the presence of the market maker. Let's talk about how we trade this. What we do is very simple, rather than looking at the option premium, we keep tracking the IV drift and the covariance readings of the Call and Put option. The advantage is, these are simple numbers and are easy to track. Therefore it will always be a leading edge. If the market makers are holding their position, we simply need to hold. We don’t care even if the open interest tells us to square off. Because that open interest is exactly what the retail clients are thinking about.

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