The Derivative - Options Alchemy: How Bernie Yu of Patronus Capital Transforms Market Making into Strategic Investing

Episode Date: July 17, 2025

In this episode of The Derivative, Jeff Malec sits down with Bernie Yu, co-founder and CIO of Patronus Capital, to dive deep into the world of options trading, market making, and the nuanced art of capturing convexity. Drawing from his experience at Optiver and his journey to founding Patronus, Bernie shares insights into how a four-person team competes in the hyper-competitive options market by focusing on S&P 500 volatility. The conversation explores Bernie's unique approach to trading, the importance of liquidity, and how understanding market flow can create strategic advantages. From his Australian roots to the trading floors of Chicago, Bernie offers a fascinating look into the mechanics of options trading, risk management, and the evolving landscape of derivatives markets. SEND IT!Chapters:00:00-00:54=Intro00:55-06:14=Actuarial Science, Cricket, and the Trading Floor: Bernie's Multicultural Journey into Finance 06:15-21:40=Market Making Decoded: The Art of Liquidity and Convexity21:41-31:58=The 0-DTE Dilemma: Navigating Options Market Inefficiencies31:59-41:36=Competing with Giants: A Four-Person Team's Edge in Options Trading41:37-50:35=Liquidity Dynamics: The Hidden Engine of Financial Markets50:36-57:16=Future Horizons: Tax Advantages and Market Expansion Strategies57:17-01:05:41= Market Time Machine: Lessons from Black Monday and Future Market InsightsFrom the Episode: MMI Index Blog postBlast from the Past - How Futures saved StocksFollow along with Bernie on LinkedIn /Patronus Capital and check out the Patronus Capital website at www.patronus.capital!Don't forget to subscribe to⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠The Derivative⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠, follow us on Twitter at⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠@rcmAlts⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠ and our host Jeff at⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠@AttainCap2⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠, or⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠LinkedIn⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠ , and⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠Facebook⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠, and⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠sign-up for our blog digest⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠.Disclaimer: This podcast is provided for informational purposes only and should not be relied upon as legal, business, or tax advice. All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of RCM Alternatives, their affiliates, or companies featured. Due to industry regulations, participants on this podcast are instructed not to make specific trade recommendations, nor reference past or potential profits. And listeners are reminded that managed futures, commodity trading, and other alternative investments are complex and carry a risk of substantial losses. As such, they are not suitable for all investors. For more information, visit⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠www.rcmalternatives.com/disclaimer⁠

Liquidity is the biggest driver of everything. It's the driver of risk, it's the driver of reward, performance. Everything is about liquidity. Following the flow is just following where the liquidity is going. Welcome to The Derivative by RCM Alternatives. Send it! Hi, my name is Bernie Yu. I'm the co-founder and CIO of Patronus Capital

and we're here to talk about options and convexity on The Derivative. Thanks, Bernie. how are you? I'm good thanks, how are you Jeff? Good, where are you? I am currently in the northern suburbs of Chicago, so enjoying the summer here. Which suburb for all those Chicago folks? I am in Winnettica actually so not so far from the Home Alone house. Right, didn't that sell recently like a year ago or something? Yeah it's constantly turning over I think it's probably turned over to two times since we've been here. I think someone wanted to buy

it and make it like an Airbnb right right? That would have been you could stay there. Yeah, that would have been neat. I think the council has put a fair bit of regulation around it, though. Great. Well, give us a little background how you got started, how you got in the biz, and then we'll dive into the strategy. Yeah, so I I went to school Australia, in Sydney, New South Wales. I studied actuarial science and financial economics, had my plan to go into the insurance business,

and one day a trading firm was doing like a recruiting drive. They were handing out these red t-shirts and I wanted a free t-shirt, you know, being in college and whatnot, try to get your hands on anything free. And so they were saying, okay, if you can do this 80 question quiz in eight minutes, we'll give you a free shirt. So did that, passed and got into it. What kind of questions? They were just basic arithmetic and pattern recognition questions. The emphasis was on speed and making sure that you could just get through all the questions. So the trading firm that I

started working at in 2012 was Optivope and that was in their Sydney office. So I was there trading, started on like Hong Kong equity index options, and then moved over to the single stock options, worked a little bit with the JGB options. And then, you know, in 2014, the you know, there was like this push to get traders over to the US office because they thought rates were going to go up. Anyone that had a little bit of rates-volve experience come over to the Chicago office. I didn't know much about Chicago at all. Back then I knew Michael Jordan and the Bulls. That was bad. And I came over in January 2015. So that's how I kind of came over to hit this side of the pond if you will. And so you're Australian?

I was born in Canberra and then raised in Brisbane. So yeah. We're thinking about going back next Christmas. My wife studied over there in Fremantle and we've been over there. Oh perfect. Two times. It's a long trip. It's a long trip.

Long trip. Well that's why you got to go to Christmas, you get two weeks with the kids. So that blows my mind. So OptiVir just said, hey we don't care about, we're just gonna go around campuses and hand out these quizzes and see who passes it. Yeah exactly, I mean I'd seen in previous years people wearing these kind of red shirts. That was the thing. So the university I went to is UNSW and people had these red shirts. And I was just looking out for free stuff, you know, college kid. And yeah, Optiver, part of their marketing

campaign was was handing out these red t shirts. And so that's how I got hooked. And I like I said, I had no intention of entering into the financial markets and trading. I came from an actuarial background so I was very much focused on insurance. That kind of thing. You've got to get out of there. Yeah, it's a lot more interesting, should I say. It's a lot more interesting. And what's your Australian thing you do? Do you surf or do anything cool like that?

So I would say my brother and I were probably one of the first ethnically Chinese participants in cricket. A lot of people who like it's quite predominantly played by, you know, the subcontinent. So a lot of, you know, Indian and Sri Lankans is very popular there. Like in, in, in China, it's crickets, not a, not a thing there. And then as my parents as immigrants, they didn't really know about it. My dad studied in, in the U S actually. So he didn't really know anything about cricket. So, but he wanted, and my mom wanted us to kind of assimilate to the culture and just try, you know, quintessential

Aussie stuff. Cricket pick one of them. So yeah, I mean, my brother played, you know, at a pretty high level. So that was like one of the cool quirky stuff about us. But you know, apart from that Aussies, we just we love sports, we're pretty chilled. So there's nothing too special or unique. Unfortunately, I think I've acclimatized to the weather here so I'm less used to the heat and the humidity. But yeah, no, I love

the beach, I love the salt water, it's weird, you know, swimming in Lake Michigan it's just not the same. You piqued my interest there with JGBs. Like what did and what do the options look like on those? It's got to be a weird market being so... Yes, yes. ...hanged all the time. So JGBs in 2014 is probably very different than what JGBs are like today. The options market, it was highly, highly professional, right, you don't have any retailers in there. They were massive contracts, slow moving,

very one way, very flow driven. And you just had to kind of be very diligent about managing your risks as a market maker, because you had to take down the inventory and you had to move quickly to try to get out of any toxic flow. So it was a very different style of trading compared to Hong Kong single-stock options where it's you know you're trading 50 names and you're just trying to spread it off, lay it off, there's a lot of liquidity, a lot of different risks to manage. Whereas with the

JGB options, it was kind of very concentrated, very flow based, you had to know who the players were, speak to the brokers, understand that. So it was a different style of market making. Yeah, always at risk of the government or the central bank coming in and saying something and risk of the government or the central bank coming in and saying something and boom. Yeah, yeah. I think right before then, the reason why I got a little bit interesting was with the whole Arbenomics, just unleashing all that stimulus. I was also part of, I traded a little bit with the Nikkei team as well and just watching Nikkei just uptick during that period was wild as well and just seeing those correlations between the equities and the fixed income side from a vol perspective.

You could almost argue it did you a disservice like learning in the JGBs, right? You weren't seeing massive volatility in flows it's just slow moving right well initially yeah when I came over to the Chicago office I initially traded on the US treasury market options and that was more akin to the single stock option there was a lot more liquidity, a lot more turnover, a lot more flow capturing that down. And then towards the end of 2015, I moved over to the Euro dollar desk at the time, there's no more Euro dollar product now, it's now SOFA. And I was market making the short term interest rate options there. That was more akin to JGBs where it's heavy one way flow. and you just have to understand the price at which you're buying or selling and you either hope that it reverses out so

you can take your scalp or if not like just know that whenever you hold to expiration that that's the variance that you're gonna run and hopefully you ask for enough of credit to take on that position, to take on that risk. And then let's back up a step. I'm sure people know the Optiva name, but maybe not exactly kind of what they were doing and how many people were doing it. So maybe give us a no longer work at Optiva. Yeah, but Optiva is a Dutch trading firm. They started off in the 80s in Amsterdam. Optiva stands for like options trader.

That's how the name came about. And it's bread and butter is market making. Primarily in the option space, they've branched out to, when I was there, branched out to market making futures. And we call them like Delta One strategies. The whole ethos of Optiva was when you trade, it was learn the philosophy of trading, learn the philosophy of market making, and you can take that those skills and transfer them to different desks. So if you were an options market maker on Hong Kong single stock options, one day,

the next day you get plonked on the Japanese government bonds, which is quite different. So long as you abide by the same philosophy, you'd be fine. If you plonked over, you moved to the Chicago office and started trading U.S. Treasury options, you'd be fine. And so it was understanding how we made money, which was just market making, taking down the bid ask spread, providing liquidity, providing that service to anyone, to all hedgers and speculators in the options market. And maybe not to dumb it down too much, but explain market making real quick too. So it's right in your modern equivalent of the old floor traders in Chicago, right?

Right. So market making, the best example was when we were kind of doing our marketing campaign, you can think of it as a grocery store. The market makers at the grocery store where you have farmers that need to sell the products to the grocery stores, and then you have the consumers that need to to buy the produce from the grocery stores and then the grocery stores are there to create that market for people to to buy and sell and you know take Whole Foods as the grocery store for example like that you know when they're going to be open there's always going to be that liquidity there if they didn't have the grocery store you have to know when to go to the farmer, what

time they were available. The farm would have to know when the retailers would come, the consumers, the end users would have to come. And so there would be constantly this liquidity mismatch. Enter the market maker or the grocery store, and then they're there to constantly provide liquidity. And because they're providing that service, the idea is that they get compensated for that liquidity providing.

But grocery stores are notoriously low margin business, right? But same with market making, very low margin, just do it a lot of times. Yes, so the spread relative and to the turnover, yes, I mean, they are quite low margin, especially when you compare to say, you know, value funds, right? You know, if you think about Warren Buffett's, you know, Berkshire Hathaway, right? The margin that they have the amount of, if you will, edge whenever they go by, you know, back, you know, way back when when he bought Coca-Cola, like what was his valuation? What was the price that he was entering? That difference, call that edge, call that margin, yeah, it's probably a hundred, a thousand times greater than each trade of a market maker. The difference being is that while it's low margin,

it's high volume. And that's kind of, it's the combination of the two which gives you the revenue. So then you, we buried the lead here. So then you start Patronus, your own baby here. So what did that look like? You said I've had, I've learned enough. I'm ready to go out. What was the impetus? Yeah, I learned a lot from Optiva and they were really good to me. And I learned a lot. I had a good chance to give back as well. We picked up a lot of interns. But at that stage, I wanted to scratch that entrepreneurial bug. I wanted to go out and be my own boss, do my own thing, have my own schedule. I had to think about what assets that I have,

like mental assets, right? Like what age did I have, et cetera, et cetera. And then my partner, he was like, I've got a family office that's willing to seat us. If you're interested, let's think about maybe if you want to set this up. So he decided to leave in 2019 to set up all the legal work. I was thinking about it. And then basically I had my first child in March of 2020. So the markets went wild. I decided to give my leave and like, okay, you know, this would be a great paternity

leave. And then I onboarded with Petronas in May of 2020. And so we kind of started everything together. Our initial intentions at the time, and I think what he was doing initially when the fund started was a little bit of macro, a little bit of interest rates because we traded the Eurodollard desk together and rates went to zero. There was no more interest rate volatility. So we pivoted.

We started trading just other kinds of volatility strategies. You know, we did a little bit of short VIX at the time. We did a little bit of directional biases on gold and yen. And we tried to, you know, just, you know, explore and see what would make money. And then we ended up settling on trading just S&P 500 volatility. It's highly liquid, you know, vol was relatively high back then. There was a lot of opportunity in the traditional market making space, you know, that we had learned at Optiva.

And so at that time I decided, okay, let's just hunker down, let's stop exploring and let's stick with market making style of investing on the S&P 500 options. And we've been doing that ever since 2021. So explain that market making style. What do you mean by that? Yeah, so when you think about market making, the typical hold time of your positions can go anywhere between, you know, microseconds through to a couple of days, maybe a week or two. What we do at Patronus is we try to extend that holding period of time to two to four weeks. And then that's kind of the bridge between your traditional asset management,

which is long-term valuation, buy and hold, etc. So we try to marry asset management with market making. So that's why it's market making-esque with the essence of staying flat risks, looking at your risk table, trading the entire, you know entire board of strikes that's available, seeing what has excess supply and demand and honestly supporting the market makers in terms of the liquidity that's being given to them. And then so as it developed, not necessarily long vol, not necessarily short vol. You're just in there in the middle.

But would you call yourself relative value vol or vol R? Yeah. So when we started, that was really what the name of the game was. Basically what we did was we created two volatility models. The first volatility model was the market volatility. If I needed to go get a price for a call spread and put spread, I knew exactly where the market would make that and what my entry and exit costs would be. Our second volatility model was actually our edge generation.

Where should the market be? And having the difference of those two models allowed us to market make in the sense that we knew where the prices were, but then having that second model being able to disagree with the market and then actually take on positions and invest over a longer time horizon than a traditional market maker. And so when you're considering that with all the different market makers, right, you're not just, take a step back, how many Optivers in the world are there, right? Like five, six big firms doing this similar thing?

The major players, there's probably three to five. I would say the top tier, there's maybe three, and then second tier, there's probably another two to five. I would say the top tier there's maybe three and then second tier there's probably another two to three and then you have a plethora of smaller groups although they are kind of being swallowed up now by the larger groups because they have the infrastructure because they have the access to flow. And do each have their own twist so when you're trying to make your own value for that spread as you said you're saying here's what I think the market makers would value that as? I would say, this is purely speculation because I've never worked at another market making firm, but talking to like floor traders, because they always talk amongst each other, I would

say 90% to 95% of the time there's a consensus, especially on what the market price should be in terms of what inventory to hold, in terms of what positions to actually keep and to dish out, then that consensus probably drops down to 60 to 50%. But there generally is a consensus amongst market makers, and that's just simply boils down to the flow. And the flow, explain what you're looking at in terms of flow there. So retail, institutional, the market makers themselves. Yeah, so it's mainly, you know, we follow a lot of people like on Twitter

or X nowadays, you know, just putting out like what kind of flow is coming down. I personally like to follow a lot of ETFs that have options embedded into them. We do see that flow coming through, especially in the pit now because the broker has more color now. We can talk to people around to say, okay, what kind of institution is doing this? What kind of size? How often? What conditions do they stop the flow? And I think that's really important as well. And the classic one is you have someone who likes to do the buy right strategy, just come in and sell his call.

There are the quote unquote more sophisticated people who try to sell a call and then buy a put spread and then finance that. I think JP Morgan has a very large ETF that does that. There are other, I think starting at the end of 2021, beginning of 2022, there was this large fund that was selling a lot of the far downside like Delta 5 puts. And that, you know, it's just understanding the flow when they start, when they stop and, you know, behavioral economics comes into play. Why are they doing that? What's their mandate, right?

Etc, etc. So that's part of the game that market makers have to understand. So you don't, you know, you try to avoid to buy the first level, you wanna buy the last level, et cetera, et cetera. And as Patronus, that's kind of what we do as well. But what we try to do is strip out the need for that infrastructure, that heavy overhead, and forego the quick instantaneous money,

the high turnover that requires a lot of overhead, we sit back, let the market, let the dust settle a bit, and then we say, OK, where has there been too much supply, too much demand, and let's support the market. What is the market's impact on the market? Taking a step back, the JP Morgan hedge equity, I believe, right? It's like 28 billion something.

That's a good example because it seems it makes sense to people like, hey, here's this 30 billion call it behemoth in their prospectus is what they need to buy and sell. It seems an easy trade to kind of get in front of those trades, but I think it's much more difficult than that. They kind of hide their size, they do different things, they use different market makers. So talk to that for a second of why that isn't as easy of a trade to just trade that flow as people might think. Yeah, because I mean, if you take on that, if you were the sole market maker, the sole

liquidity provider behind that, there are a lot of freaks. No thanks. Yeah, you're buying a lot of premium, right? There's a lot of curve risk that you're buying. There's a lot of all these different things that a traditional market maker doesn't want to house on their books. And so they have to adjust for the right price. They have to adjust for the right timing of it because these guys that are selling it, they actually don't bear any of the risk. They just sell it and forget it or like execute it and forget it, right?

It's actually the owners of the ETF that bear the risk. And so for the market makers for such size, they have to price that appropriately and making sure that if there's opposing flow that's naturally coming in as well then they can be more competitive. If other people start like copycatting, you know there's a little bit of copycatting going around. If there are more copycats then the price that they have to ask for is going to be a little bit more skewed than normal and so that's why it's not so easy. That's why you know it's it's not arbitrage, it's not front running because there is risk.

They might stop on one particular day. It's all guesswork, it's all probability, it's all chance. And at the end of the day, what everyone's trying to do, and this is why it's like the perfect capital markets, is just to get the best price for the level of risk that they're taking on. And then for you guys, you're saying so it's one, understanding that flow, but two, matching it with your valuation of, okay, we think this is oversupplied here, given our models valuation, we're going to sell into that.

Are we going to buy it if it's oversupplied? Yeah. So what we tend to do is, and we've, you know a lot about this and this is kind of where the convexity piece Comes in is that when convexity is cheap you should buy it When convexity is expensive that doesn't necessarily mean you should sell it and you want to buy something that's cheap But you don't necessarily want sell something that's expensive because you could get even more expensive And even more expensive and that's when things can get a little bit hairy, right? but yeah, it's understanding the flow and what

People have natural tendencies to do right like a lot of typical short funds. They'll sell strangles They don't sell straddles, right? There's a lot of wing selling. So if you think a lot of the buy right, that's selling calls, but those calls are rarely at the money options. They're always upside. And then if you think about put selling, yes, you do have some funds that sell a little bit about the money, but a lot of them sell the far down side. So when you, when you have a look at this, it's, there's a lot of flow, which is pushing the wings down. And so there are definitely opportunities out there where you can buy this far convexity, I would say global convexity quite cheaply.

And so that's like what, you know, that's that's like a new strategy that we've kind of created where we really isolate that cheap convexity, not local convexity, but I call it global convexity. So protecting your portfolio down 15, 20, 30 percent. And talk through exactly what you mean by convexity in that case? Yeah so the classic form of convexity is owning a straddle where your payoff is like a V shape and so when you talk about like a mathematical function you can think of it as it's like a U, it's like if you go to the right it goes up when it goes to the left it also goes up so whenever you have a portfolio that has that kind of a payoff, then that's called long convexity in your portfolio. The problem with convexity

and why a lot of people try to avoid it is because you usually have to pay for it and pay a lot for it, right? And so if nothing happens, your payoff, you lose a finite amount, but it is finite if nothing happens. And then you need that movement in whatever you have that convex exposure to, to make money. And so you're not considering the acceleration of the move as cheap convex or you are in a bit? the move as Chief Convexer, you are in a bit. So what we try to do is instead of getting into a U-shaped payoff, we try to get into a W-shaped payoff. So what that means is, you know, we have a little bit of concavity in our portfolio locally, which means that, that look if nothing happens

then we sit and we're able to collect a little bit of premium if something moves a little bit then we rebalance and You know mark to mark it you might take on a little bit of a drawdown Because there's no there's nothing there's no such thing as like free arbitrage, right? Yeah and then if you really start to accelerate then that's when really things start to pay off. And this idea really comes down to the ability to replicate an instrument that kind of gives you that flat payoff locally. So locally you're not even convex nor

concave and then globally you are convex. So it's kind of like a flat U payoff, which kind of looks like a little bit of a squiggle of a W and those are the kind of payoffs that we're trying to replicate. And globally versus locally, you're not talking markets, you're talking on the curve and like locally. On the size of the move for the particular future, which we're talking about is the S and P five. Right. And so locally is around the money and globally is size of the move for the particular future, which we're talking about is the S&P 500. Right. And so locally is around the money and globally is out of the money either direction.

Yes, exactly. Yes. Love it. And how do you not fall into the trap of it's cheap because, right, convexity is cheap because it's such a low probability of happening. So, yeah, I can argue it's cheap for a reason or it's inexpensive for a reason. Then it gets into the difference between inexpensive and cheap. Yeah. So a lot of the reason why it's cheap is because of the flow. And quite often we see either the day of or the hour after or the next day after that flow has been executed when that level of

convexity gets quite cheap. And then what happens is, let's say market makers try to anticipate that and for whatever reason the customer decides not to sell the convexity, then people have to chase that and then it gets quite expensive again. So that's when you don't want to sell it. You just either you let it ride back down to cheap levels. And the reason is because like that, you know, convexity just like volatility is unbounded on the upper level, right? So we try to from a risk adjusted perspective, try not to ever be short risk as such. Because from a risk adjustments perspective it doesn't make sense. And how do you define risk in that

in that case? In that case we look at like down a couple of levels. So one measure that we look at is what the span margining requirement. So we predominantly trade on the Chicago Mercantile Exchange and they have their span margin calculation methods, which is they have a matrix, I think, of like 16 different scenarios and then they take the worst one and that's what your capital usage is. We look at that, we look at value at risk over one day, over till expiration, and then we look at down 32% strike vol up 25 vol points. And then we just have to stay long those in the down scenario. So it's mainly the downside where we try to make sure that we're always positive And then switching gears somewhat related like how do you feel?

Most groups get in trouble with this kind of approach right a lot of relative value I'm short this part of the curve among this part of the curve and Invariably that short part loses way more in us in a spike in April Kind of move than they were anticipating. So yeah, go ahead. Yeah, we got into a little bit of that pinch and this was that learning experience. And it's this idea of when you're either locally convex or you're locally flat, but globally you're actually concave. And then that's

when you can get into a little bit of trouble. So for example, you might think that if you have a port 1x5 on or 1x3 on, you might be flat. You might even be long a little bit of gamma, right, if you move around a little bit, because you own that one leg that's closer to the out of the money. Yeah. But if something really bad happens and it happens really quickly and you can't hedge, well, then you get very short quickly. You get your portfolio becomes quite concave and it's, you know, it's this idea. It goes back to the basics of options pricing, which is the ability to, to hedge continuously hedge, right?

That's where the Black Scholes formula came from, your ability to continuously hedge. And when that ain't so, that's when people get into trouble. I love it. That's a good RC line. When that ain't so. Yeah.

Um. Yeah. Um. Um. Um. Um. Um. Um. So, I think it was August last year. There was a bit of an event there, right? So short gamma got taken out again here in April. So what, and you guys are know you'll go to the sidelines, right?

So what we usually do is we will, let's say right up to August, we didn't have that bigger position. And the reason why was because we were just constantly tricking up, there wasn't that much disagreement in the market, the flow was fairly stable. And then we had a little bit of a position on, but then once the index fell, I think it was a liquidity issue in Japan that kind of precipitated everything. That's why I was quite short. There was a little bit of a dislocation. And then once the convexity was cheap enough because it's

somewhat counterintuitive, but as instantaneous volatility goes up, so you're at the money, volatility goes up, usually the price of vol of volatility comes down. And so once that vol of volatility comes down, it can come down to a point where the price is quite nice to own the vol of vol. And that's what I kind of call to the layman like long global convexity. You know, there's like voma, that's another Greek that you can use to describe that. But the idea is you stay locally flat, concave or convexity, and then globally you get long convexity. Yeah, so using all your Greeks, what does that look like in terms of Greeks? So yeah, we try to stay flat, you know, vega, gamma, theta, vana to a certain point,

like in terms of that derivation of vega as we move around as well, but then you can get long vommer, which means that as vol goes up you get longer vega, as vol goes down you get shorter vega. So it's I like to think of it as the gamma of the out the money vol. And then that's where a lot of people who are selling that stuff get unstuck and that's where I think there's quite a nice opportunity for us to kind of reset that price and say, like, look, you should actually be selling this for a higher price because you're selling it way too cheap right now.

So that's where everyone's looking to get out and you'll raise your hand and back. OK, that's where I can make a market. Exactly. Yes, exactly. Yeah. And so totally focused on S&P right now? Yes, so we're a four-man shop right now. Our focus is solely on just making sure that what we do, we do to the best of our abilities. We've got three strategies running right now that are independent, that source alpha differently. But because the S&P 500 is so liquid, because the CME, it's such a powerful exchange in the sense that it has a lot of combination strategies where you can

piece together call spread versus put spread with an extra tail and things like that, the liquidity provided there is amazing. And so for the time being, we're just gonna keep maxing that out. And what are you across the board? Zero DTEs, weeklies, monthlies, quarterlies? We primarily launch positions with an expiration between four to eight weeks

and we will hold them to two to three days left. The reason why we don't play in the zero DTE game is A, I had a look it's pretty efficient from a positional standpoint so if you just wanted to come in and take markets in zero DT because there's so much liquidity, you know, just going back to regular like capital, you know, efficient markets hypothesis, it's pretty efficient. Where it's quite profitable for the market makers is because of the high volume. If you can capture the bid our spread, that's when it becomes quite profitable. But we stick farther dated. Yeah. If you can capture the bid our spread, that's when it becomes quite profitable. But we stick farther dated. Yeah, which for a market maker is quite far dated.

But if you go to like a bank, anything under six months is considered quite heavy gamma, which for a market maker, that's very different because heavy gamma is like day off. What's your just sidebar for a minute on zero DTE, you mentioned highly efficient. Do you think there's, right? Was it two years ago, everyone was saying this is going to be a blow up risk and there's all sorts of unknowns here. What's your thoughts? It just is what it is. I think that it is efficiently priced at a global level.

There are definitely pockets where it becomes inefficient. I think hedges are misusing zero DTE options. I think they leave themselves. So if you think about managing global convexity, there's also a time component. You don't just want to be globally convex when there's an event. You also want to be long convexity when it's cheap, when it's quiet, when you don't think to own it.

And so people can get into a bit of trouble when they have this quote unquote buttoned up risk strategy. But if something just randomly happens and they don't have it because all they do is buy this heavy theta zero DTE stuff, then they can be caught a little bit offside. For example, like Liberation Day, the straddle going into that event was I think like 20 or 30 ticks. It was basically like half a percent and we moved like 3% on that day. So if people aren't buying it, yeah, because people weren't pricing it. People weren't pricing just how much we would move. And so when people aren't, if people are constantly buying zero DTE options to cover their risk to get long globally, convexity,

it's quite expensive. You're better off just buying a one month out, a two month out, a three month out. And I think a couple of risk managers are forgoing that and they're trying to be a bit cute and clever with it and saying, okay, I'm only going to buy it on CPI day. I'm only going to buy it on NFP day, on Fed days, right? On Apple earning day. Yeah, when something is supposed to happen. Exactly. Exactly. And do you think that's skewing, do you see it skewing the actual pricing of the options you are in?

Right? If those people aren't trading the three month option anymore, they're just going on those days. Is that bringing that vol down in those options? It's definitely bringing down the wings. I would say at the money, if you talk to 95% of options traders, they understand realized volatility versus implied volatility, especially at the money volatility. That's very efficiently priced part of the volatility curve, right? The equivalent is, you know, Apple, most analysts know roughly where Apple should be trading, where Meta should be trading out from that, right? They're over covered and everyone knows, and there's minimal edge in actually doing like relative value apple versus

you know another big blue chip that's the same with at the money volatility where I think there's less coverage less understanding less ability to replicate is in the wings so So for example, many people can tell you how do I replicate a portfolio that if the future moves up one tick, I make a dollar. If the future moves down one tick, I make a dollar from the strike. That's just a straddle. But less people will be able to tell you how do I construct a portfolio if overall level of volatility goes up by one point and make a dollar? If overall volatility goes down by one point, how do I make a dollar? How do you replicate that strategy? What is the price for that? Less people know that because less people know that I believe it's less efficient. Does that come back to that the VIX is not tradable,

right? It's just an index. So it's a collection of all those prices. So if I'm trying to capture that 1% increase in vol, where do I go to capture that? Yeah, that's part of it. And that's why people turn to the futures. But the problem with the futures is the term structure. You just get killed on the term structure. And it's still a future on that index. So I don't know if that solves the problem. Yes. Yeah. Well, I mean, you can actually, I mean, that is a strategy that I know a lot of market

making firms do is trading the strip of options, which ends up actually being closer to a variant swap rather than a vol swap. And they trade that against the VIX futures. And if you do that, you do get a little bit of convexity by trading long the strip versus short the future because you're long variance and you're short vol. So variance has that quadratic effect over the vol. again, another place to find convexity if it's priced appropriately. And what are your thoughts of like how does a four-man team trading in the most competitive market in the world compete with the OptiVers and Peak Sixes and all these groups who have

hundreds of, you know, PhDs and yeah, it seems an impossible task, but that's the entrepreneurial spirit you wanted to pick up. Exactly. So it's something that I picked up at Optiver, which is if you're going to do something, do it to completion. Don't spread yourself too thin. You know, it's tempting, for example, right now to let's go out and trade oil options with what's happening over in the Middle East right now. It's tempting to say, okay, let's stop trading S&P 500. Let's start trading single stock options. Okay, that's not working. Let's start to trade this. Let's start to trade that. What we do by that is we don't diversify. We just stay in our lane and then we just try to make it the best possible thing that we can.

And then once we've kind of maxed that out, then we decide, do we create a new strategy or do we trade a new product? And so right now our team is two developers and two traders. So my partner and I are both the traders and two other employees, they're developers. And so the developers, they're really focused on how do we make operating as smooth as possible? The back office, you know, sending out the confirmations, making sure that the reconciliation is fine. I think with a firm our size, market risk isn't the biggest risk. You know, a 20% move in S&P isn't going to blow us out. What will blow us out is if we don't know what our position is, or if we think we have one position but we actually have another position. And that's why this focus on

reconciliation, this focus on back office, this focus on having automated processes to remove human error is crucial. And so it's like having that, you know, dedicated focus to risk in addition to making money, which I think helps us, I wouldn't say be better than the big guys, but at least like compete amongst them. Because we're going after a different piece of the pie, because we're not shooting for those nanosecond trades. We still connect over the internet, through our third party software, through to the server exchange. So we are hundreds, if not thousands of milliseconds behind the true high frequency traders. But would you

argue that's your edge in a little in a weird way right? Exactly. They're ignoring this other part. Exactly and when when people ask us okay you're a market makers but then you know how do you still market make the the main source of edge is that we're not overfit because we don't have to continuously provide liquidity. And that's the biggest difference. We can be selective about when we provide liquidity. And that's our edge, if you will. But isn't the market makers, is that a bit of a misnomer?

They don't have to continuously provide liquidity either. Like they have to make their partner's money and whatnot. But right. And you see that in April, they just pull all their bids and offers. They're like, this is too crazy. I'm on the sideline. It's it's not that they don't have to. It's that they've built their business that the more they're able to provide liquidity, the more money they make.

So I think that's a big... Because they've invested in this infrastructure, because they have, you know, a one-to-one trader to dev. I know we're one-to-one traded to dev as well. But the fact that they have all this overhead, anytime they're not in the market, they're theoretically just burning theta at a partner level, right? Yeah. If they're not providing quotes in the market, yet they can

sit out, but they're just burning theta for the rent that they're paying for, for the on-prem calculations, for the army of people that they have working. That's why they need to be in the market the whole time as well. That's why there is a nice synergy with exchanges and market makers, because exchanges are there to be able to provide the opportunity for liquidity and it's the market makers that provide liquidity. And what we do is we also provide liquidity as well because we do believe it's a service that we're providing the overall economy to get a better price for whatever they need to trade. In my opinion, the retail trader is thinking they're like a utility and they're going to provide this liquidity at all times. So yes, they have an economic incentive to provide liquidity as frequently as possible.

But at some point that tilts and if it's a really crazy market, they're going to blow out the spreads, all this stuff. Where the retail trader to me doesn't quite understand that of like, no, I need to go in there and see a five tick wide option spread at all times. Yeah, yeah. And I think that's understanding the spread and how that relates to liquidity. understanding the spread and how that relates to liquidity. And I think, you know, when I, you know, to take this, to talk about, you know, my investment philosophy and just like the general like ethos of how the markets work, I think liquidity is the biggest driver of everything. It's the driver of risk.

It's the driver of reward performance, everything is about liquidity. Following the flow is just following where the liquidity is going. If there's a lack of liquidity, there's an increase in risk. That's why the bid ask spread widens out. I think the Fed measure of liquidity is actually not just how many bonds transact, but it's also the bid-ask spread that dealers quote. It's all driven by liquidity. And you can talk about fundamentals and you can talk like stocks are now at all time highs. There are, you could argue a lot of headwinds,

but the biggest tailwind is liquidity. And so whatever risk or reward that people try to pin down to fundamentals, at the end of the day, my belief, the main fundamental that drives everything is liquidity. And you could care less where it comes from. Exactly. Yeah. You could care less where it comes from. Exactly. Where you kind of start to care about where it comes from is if the liquidity starts to change. For example, right? Like if you have an asset where in a lot of high liquidity times, people are pouring their money into that asset, but in low liquidity times, people aren't pulling out from that, then that's a great asset to own,

because it's going to go up in good times and it's not really going to come down in bad times, because people aren't pulling out of that. If you have another asset where it's going to go up a lot, because there's a lot of liquidity people are pouring in, but when things become less liquid, people pull out from that, well then it's just playing chicken, right? I'm going to ride it, ride it, ride it, and then, oh, liquidity's gone, get out, right?

And so understanding, and this is what value investing tries to be all about, right? The idea is that when there's a lot of liquidity, just pick up your value and own it. But then when there's no liquidity, those companies are still good. You're still going to get your dividend. There's still, you think about your Walmarts, your Costco, the consumer, the non-discretionary stuff. That stuff's going to be there.

And so, you know, you understanding that liquidity, same thing with options, same thing in the volatility space, right? Like what's going to be there day in and day out? And if it's not in vogue, what's what could change? For example, like skew, right? Skew to the downside. Yeah, it's going to get expensive. yeah, it's going to get expensive. Yes, it's going to get expensive.

And then if we have a sudden crash, are people going to start buying calls over puts? Like probably not, right? Like yes, once you've found the lows and let's say, for example, the Fed injects a bunch of quantitative easing again, just like they did in March and April of 2020. Did we suddenly see call skew in the S&P 500? No, we did it, right? People are still scared of the downside. Yes, right? And so we have this like permanent effect of flow causing these levels, right? So, you know, it's understanding how much that flow has pushed that asset price.

And yes, I'm considering skew on S&P 500 like an asset, because you can trade that. What price is that? And is it going to get cheaper? Could it get cheaper and could it get more expensive? And just understanding those dynamics. Do you have any worries that we've created a monster, so to speak, and that the whole derivatives market, the options in particular, are almost larger than the underlying?

Right? And if we keep going on this direction, right, and the CME, who knows, they could launch hourlys or like they're for profit, they'll just keep launching new strikes and new ways to trade it. So when does it become a problem? Or do you think it will ever become a problem that the derivatives overwhelm the underlying? It's quite topical that you bring this up because you see the current lawsuit that's happening over in India right now. I didn't know of it. Okay, so that's an example of where the liquidity in the options market dwarfs the liquidity of the spot market. We see that in other equity indices like Korea, where there's an

extreme amount of liquidity in the options of the derivative space and there's less liquidity in like the cash markets. Now in terms of whether that is going to be a disaster that melts down the financial system, probably not. There's too much regulation around that, but it does make it more susceptible to manipulation. It does make it more susceptible when you have something that's leveraged and anything that's leveraged up, you can kind of take a big position in whatever's leveraged and influence it by a minimal amount. That's not to say that only happens in the options market. You could see that happening before the 2008 financial crisis. Everyone was levering up on these mortgage instruments and things like that, and there

was just super leaven. In the good times, they were making a killing, but then in the bad times, it went quite all right. So in terms of the overall financial safety of the markets, I don't think we're too big. In fact, I think like in the US anyway, the cash market is very robust. There's a lot of regulation around that. And if anything, you know, I welcome this additional education, this awareness about options and people trading it, because I do believe the options market and the derivatives market is the cleanest form of insurance on

the financial markets. Coming back to my actuarial background, I do view options as insurance instruments and your ability to buy and sell them is the same as your ability to buy not so much sell insurance. You'd have to be like an insurance company to take that side. And real quick, what was the Indian lawsuit? Some company that had lost money was blaming the option traders or something? So the backstory was these two traders left this proprietary trading firm to join a fund because they said that they could replicate this strategy. And then the proprietary trading firm said, no, you guys stole this strategy, so we're going to sue you.

And then in the courts, it was revealed just how much money they were making. And then the exchange decided to investigate like how did they make so much money. And it turned out that they were taking leveraged bets in the options market and taking advantage of the fact that the cash market was less liquid than the... Oh, God. So they were moving the cash market was less liquid than the... Oh, yeah. So they were moving the cash market basically? Yes. That's what they're being accused of. Well, which you could argue was like GameStop and that kind of thing.

Like at some point, yeah, the market makers need to hedge and they're going to start buying. Yes. Yeah. And that's what the proprietary firm is saying. They were hedging that they needed to do this, etc. So I think that came out over the weekend. It'll be interesting to see how everything actually unfolds. Super interesting. All right, so what's next? So S&P for now, but what would be next once you get that? So Word has it that the CME will start listing single stock futures this year. And then after that, they'll list single stock options. Single stock future options. Yeah.

Yes. So the reason why is because they already have single stock futures, but nobody trades them, right? Yeah. And then when you start adding the options, then it becomes exciting because the most exciting thing for us is actually beneficial to our investors because of this section 1256 rule in the tax code, which says that if you trade derivatives on futures, all your gains and losses will be taxed at 60% long term and 40% short term. Whereas if you trade single stock options, they're considered equities. And so if you buy and sell them within a year, then you're just completely taxed completely at short term capital gains.

So that's like a tax advantage to moving over to the future space. You know the background of that is the Chicago traders used to, if they had a loss on the year, they'd exit at the end of the year. Yeah. Take the loss. If I actually, I actually don't know the history of that. I just know it as a rule. Yeah. I mean, that's the history. If they had a game game they would just hold the position for their like March futures if they had a loss they'd sell so basically no one ever had a short-term gain of all

the futures traders and some IRS and one of the big traders got it and that was the deal like hey you guys got to stop doing this and they're like no way and they're like well okay the deal is futures trades can be 60-40. Just trade as much as you want and you can treat it as 60-40. Yes. So we don't hold anything over a year. So that's why it's a nice rule for us because we try to provide liquidity for our investors as well.

So we have a 30 day redemption. And then are you, this is all in a fund as of now, where you do SMAs or what does all that look like? We have one SMA and our fund. And right now it's like an even split, yeah. We'd like to take a little fun turn here and ask you if you could go back in time and witness slash trade one market event.

What would it be? Where do you think you'd have some huge edge? Huge edge? I think it has to be- Or just if you wanted the front row seat. I think it would just be a front row seat. The Black Monday, the October 19, 1987, I think just being on the floor and seeing the chaos unfolds, I know that kind of seems a bit

evil of me but just to see people's put skew positions just blow up. Seeing their calls increase in value on the downtick, because Vol is just getting so bid. That would be brutal here. Just seeing just the chaos unfold, seeing how the cool comment collected prevail, I think that would have been an awesome experience just to learn from that. And because that was groundbreaking in terms of the markets leading academia in terms of,

hey, this is what actually should happen. Right? You have the best and brightest minds of, you know, black, black and Scholes saying that, okay, this is the assumptions that go into our model. It should be a flat vol surface. And then on that day, that's the day that was credited for the vol surface, for the vol curve, volatility, smile, smirk, skew. And I think to see that kind of event cause, you know, as a new shift in the quantitative finance world, I think that would be awesome to see. We'll put a link in the show notes.

We wrote a blog post once, I think Brett Hall, Hall Trading was a Chicago prop firm for a long time. He was a floor trader in the MMI index, which was like the precursor to the Dow futures. And basically everything was shut down except for that small pit. Yeah, he bought like 10 contracts at the lows and that basically started the whole uptick. And then somebody saw it and said like, Oh my god, this price, there's a bid there. And so I'm going to buy this stock here. And it basically got the bottom and got everything rolling back up.

So I think the blog post was like how futures save the world. Yeah. Oh, that's cool. Yeah. But to that point of like it was a derivative on an index on the stock. So the right derivatives driving it. Yeah. Love it.

All right. And what do you see? We'll leave it with what do you see for the rest of the year? Tariffs? You don't care if it's crazy down, crazy up? What we're following is liquidity. Like what could cause liquidity to seize up? I follow M2, like the money supply quite closely, our print default swaps. Because I'm much more concerned about like the global, like should I be adding more global convexity to our portfolio? Right now I don't see any need in the next two to three months at least. Seems quite quite... yes you might get the occasional

little shock here and there. You know I don't always expect us to keep grinding higher even though we do. But yeah, it's just like what would cause liquidity to change in a meaningful way. We saw when the Fed tightened in 2022, yeah, that was a little bit of a liquidity event. But it was more so people taking some froth off the top. You did see that M2 money supply down. That's why it was probably one of the calmest sell-offs in the past three decades or four decades or something. It was the lowest level that the VIX got to when the annual year-on-year move was over 20% downwards.

Yeah, it was the, which killed a lot of ball traders, right? It was just a ball with a sell-off. They were long their puts and then they were long futures against it and then the puts never went in the money and they just got crushed on the ball and then crushed on the deltas and just get crushed all around. Yeah. Yeah, I think if you bought the 20% out of the money put at the beginning of the year, right? And whenever in September when we hit down 20, it was basically the same price. Yeah. It's wild, right? It's wild. Yeah. There was just no fear. And that's when,

yes, liquidity turned, but it was never like a shortage of liquidity. So that's the big question that I'm constantly asking myself. It's what's going to be the change in liquidity? And that's why, yes, it kind of does matter, like where this liquidity is coming from, you know, and what's going to cause them to pull out. One thing that I'm looking at right now is a lot of the private markets, private equity, private credit. We saw, you know, Harvard's endowment fund was trying to liquidate some of their private assets.

Is that going to cause if there's liquidity tied up in there, does that mean they have to come to the public markets to liquidate? We had a head of the Baylor University endowment saying they're moving less out of privates more into public markets because they're worried about the capital calls and just basically the liquidity. That's actually a liquidity boost then for the public market. Yeah. Which is, you know, and that's why it's such a tricky game.

But you know, if there's not as much debt, if there's not as much leverage in the market, and you know, with the advent of AI, and there's a lot of productivity from it, then there's not as much leverage in the market and with the advent of AI and there's a lot of productivity from it, then there's no reason why we should experience a significant drawdown, a significant liquidity event. But when that changes, when you start to see signals on the horizon suggesting otherwise, that's when you really want to be prepared. And that's why I think the options market, people trading the derivatives, they have such a nice insight into being able to trade these alternative assets that really aren't linked to the Delta

anyway of equities of whatever underlying that they're trading. We need liquidity futures. Yeah. Then we can just be like, all right, I've got some liquidity. I'm all good. Yes. We'll tell our friends. Pitch that to the exchange.

Yeah, pitch that to the CME. Awesome, Bernie. I think we'll leave it there. Unless you got anything else you want to throw in there? No, I think I'm good. Yeah. Awesome. thanks for your time. Thank you very much, I appreciate the opportunity. Yeah, we'll talk to you soon.

Have a good one, Jeff. I think you're coming down to our Cubs event, right? Oh, perhaps, yeah, perhaps, yeah. Alright, we'll see you there. See you, Jeff, have a good one. Thanks, Bernie. Bye. You've been listening to The Derivative. Links from this episode will be in the episode description of this channel.

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