The Derivative - The Glory Days, Market Making & Trading Options at the CBOE with Noel Smith of Convex AM

Episode Date: May 5, 2022

This week, we're painting the picture of what life on Chicago's option trading floors was like at the CBOE...but there's a catch — we put it all on the table and needed two episodes! Today's guest came into asset management in a round-about way – trading his own money for decades before venturing into the world of other people's money…We're talking to the one and only Noel Smith @NoelConvex , Managing Partner and Chief Investment Officer of Convex Asset Management. In this two-parter, we're talking everything from the Pets.com and the Sears option pits to singing Janis Joplin's Mercedes song to a down and out trader, to steak dinners at Gibson's and a yacht on Lake Michigan. Along the way, Noel managed to fund the founding of electronic market maker Getco and create a prop firm spanning dozens of pits with 50 traders under him. How does market making in options really work, is gamma-driven delta hedging in option flow as important as FinTwit makes it out to be, and where did the floor trading edge go? It's all here. Chapters: 00:00-01:53 = Intro 01:54-09:05 = Lake Tahoe, Taxes & Thrill Seeking Sports 09:06-28:41 = In the old days, the computer was your brain 28:42-38:24 = Prop trading firms & the rise into High frequency trading 38:25-48-05 = Third Millennium, and Edge in the Quality of Information 48:06-58:14 = How GETCO came to be… Nearly Blowing Out Follow along with Noel Smith on Twitter @NoelConvex and for more information on Convex visit their website: https://www.convexam.com/ Don't forget to subscribe to The Derivative, and follow us on Twitter at @rcmAlts and our host Jeff at @AttainCap2, or LinkedIn , and Facebook, and sign-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, visit www.rcmalternatives.com/disclaimer

Welcome to The Derivative by RCM Alternatives, where we dive into what makes alternative investments go, analyze the strategies of unique hedge fund managers, and chat with interesting guests from across the investment world. Happy Revenge of the Fifth to all those who celebrate. It's a Star Wars thing. More on that later. Got a great lineup here in May with Rodrigo Gordillo and Mike Philbrick of Resolve Asset Management on to set the record straight of what is and what isn't risk parity. Then a super interesting chat with Anthony

Zhang, who was paid by Peter Thiel not to go to college. And that's maybe the least interesting thing about him. Stay tuned for those drop in next two weeks. For today's pod, we're joined by Noel Smith, the managing partner and chief investment officer of Convex AM. We had way too good of a time on this one talking through stories of his days trading in Chicago's option pits to the founding of electronic market maker Getco to having 50 traders under him as a partner in a prop trading firm before we even got to his volatility trading in this current market. So with all that on the table, we're splitting this into two parts. Part one will be retelling of the glory days on the CBOE floor and what making markets and gaining edge in options was really like. And part two is talking through Noel's

current strategy, the vol-arb, dispersion, rates fall, and more, which is sort of his best ideas after 30 years of trading options. So let's get on to part one. Send it. wheat, like cotton, corn, and more. Move. Who are the players? What does the future look like? Go find out over at the Hedged Edge. Find it on Spotify, Apple, or wherever you get your podcasts. And now, back to the show. Okay, we're here with Noel Smith, coming to us from his somewhat new locale in Lake Tahoe. Welcome,

Noel. Thanks for having me. Alright, so, excuse the t-shirt. We're doing a bit of a Star Wars celebration this week. May the 4th, you know that? Star Wars Day. May the 4th be with you. I do. And so I don't know if you saw, we did a Jedi Evolve poster last year for May the 4th and you weren't on it. I didn't know you really yet. So apologies for that. I saw it and I was like, all right, okay. A lot of interesting people on that poster. Who would you be?

Which Jedi would you want to be? You know, there's so many. I want to say something corny like Jabba. I'll be the weirdo. When I was a kid, Han Solo I thought was the coolest. So I'll stick with that. I always thought of... So first off, I saw Star Wars in the theater when it came out and my eight, nine-year-old brain or whatever it was just blew apart. I thought it was amazing. And then when the subsequent two

movies came out, same. But a lot of the stuff in the most recent, probably 10 years, I could care less. I thought it was just so overdone and even kind of hard to follow. Yeah, and the new ones are basically just remakes with upgraded sci-fi. Yeah, exactly. Special effects. So I'll give out our listeners quick PS. Go to our Twitter and our RCM Alts.

Retweet a link to this pod with the hashtag Revenge of the Fifth. It'll actually come out on the 5th of May. So retweet that and we'll send you one of the posters. So Tahoe, let's talk quickly. Favorite ski spot there? Weirdly, I live right by Heavenly, but I like to go to Kirkwood more. So Mount Rose, which nobody really goes to that doesn't live in either Carson city or Reno is really good. And Kirkwood is probably the best overall. I've never heavily is probably the Mount Rose is over by incline village, which is, you know, billionaires row, so to speak, you know,

if you want to spend 6,000 bucks a square foot on a house, that's a great place to do it. And Mount Rose is kind of somewhere between Reno and incline village, Nevada. And now they just renamed squaw Valley, right? Yeah. They changed it to Palisades Tahoe. It's kind of, between Reno and Incline Village, Nevada. And now they just renamed Squaw Valley, right? Yeah, they changed it to Palisades Tahoe. It's kind of, you know, if Tahoe is a circle, kind of a clock, Squaw Valley slash Palisades is at 10 o'clock, Incline Village is at one o'clock, and I live at roughly six o'clock.

Six o'clock, got it. And you're on the California side or Nevada side? Sadly, the California side. Yeah. So this is interesting to me, right? Super smart guy. All you read about if you look too far into Twitter, right? No one ever would live in California or Illinois or these tax states.

So when you're right there on the border, what's the excuse? Just common sense. Everything is common sense. So when I first came here, I was actually astounded that California was much more expensive than Nevada. So I really tried to find people to give me a straight answer as to why would California trade over Nevada? You'd think at a minimum, it would arm out, sort of, right? And for the longest time, it didn't arm out. And now it's kind of gone the other way. Nevada is more expensive than California. And pretty much people that have the means or the resources, if they have the

ability, they do move to Nevada or they just buy a place in Nevada. On my end of things, why I live right by the border, but don't live in Nevada, it was availability of the house I have. The house I have ticked a lot of boxes and it was on the California side. And despite that detriment, it was still a do overall. Right. So it's just like, there's limits to, we can write textbooks and read blog posts on like, why would you live there? But there's limits to it, right? There's only so many houses. There's only, you want the right view. You want the right everything. Right. I live a hundred yards from the actual lakefront, which is pretty rare. And there's a lot of boxes that it's ticking in that regard for me and my family and stuff. So my kids want to go to the

beach. It's a 15 second walk. Um, now what's better out there, summer or winter? Summer for sure. Yeah. Get down the lake. You know, the lake, especially where I live is really shallow. So it's, you know, it's very swimmable for kids and kayaks and all that kind of stuff. And I loved a mountain bike. So there's just, you know, endless's very swimmable for kids and kayaks and all that kind of stuff. And I loved a mountain bike. So there's just, you know, endless trails for that. And, um, it's just really nice. And it's, you know, pretty cool summer or summer, uh, nighttime. And the days can get pretty hot. There's just a lot to explore.

I mean, the mountain ranges is gigantic. And if you like to explore and you like to be outside and you like to go check out waterfalls and all that kind of stuff, it's here. Yeah. Speaking my language. Um, we did last year we're in, uh,

Colorado and did some of the downhill mountain biking on the ski slopes with the big bikes and the pad looked like a storm trooper. Speaking of star Wars, um, when they have the greens and blues and blacks, right? So we did a green, my son and I did a blue.

We're like, let's check out the black. But on the side of it says aerials required. I'm like, all right, we're not doing the black. So do you do some of that stuff? Do you do the ones that require the aerials? Yes. I spend usually at least one or two days a week just at jump parks.

I'll go to, you know, you see these bike parks where basically it's a bunch of like, you know, 14 year old kids who've never been hurt. And I try to do all the same jumps. You know, I try to hit that stuff. And mainly because it's like the 12 year old in me that never was good at it. And I'm like, damn it. I want to finally get good at something that bugged me when I was a kid because I wasn't that good at it. And so now, yeah, I do the, the, the downhill bike park here, which is North star on the North side. And then there's tons of trails down by me as well that have big gnarly jumps. And so that always amazes me of like, here you

are professional risk manager, not to belittle it. Right. But like your whole job is not to blow up and have some left tail event, but it seems jumping the bike. Some of these big aerials is huge left tail risk. So how do you, how do you reconcile those? So my wife asked me this all the time. My business partner asked me this all the time. It is one of those things where it's like, you know, it is one of the most fun things that I've done and I've done a lot of crazy stuff. And it's just, it's you're outside. It's like, imagine hiking, but you know, so you're outside enjoying nature and all this stuff, but then just, you're just, you know, a giant cloud of meth is thrown over your

head and everything is more exciting and more coming at you a thousand times faster. It's kind of like that. You know, you get some of the outside, um, peacefulness, but yet you get a lot of the rowdiness and excitement that you can only get by, you know, bombing down a mountain by yourself most of the time. And if you crash, you're waking up on the back end of a bear. That's it. Yeah. You need the Apple Watch, right? That commercial who's like, the guy crashed in the woods. No, I get it. That's why I go 65 miles an hour down a mountain on skis. You get that

adrenaline rush, but something in my brain is like, it's not that danger it's not that big of a left tail um but you know one one in a million chance you break something important like your neck broken i've broken bones broke this time last year i i crashed i broke several bones in your what arm my scapula and my ribs. And I got knocked out. Ouch. But you woke up. I did. I did. Here I am. So let's move into your background a little. So you come to asset management in sort of a roundabout way, trading your own money first, a couple of decades, was it, before venturing into the world of other people's money. So let's start with the trading floor. How'd you end up standing in a circle with a bunch of guys yelling at the top of your lungs? So a couple of guys that I knew

that came out of Susquehanna wanted to start a company and they asked me if I would join them. And we started trading at the CBOE and our initial backer was a guy by the name of Stafford. And he's kind of an old school options guy, not the younger Stafford that was involved with Ronin, but his dad. And we just took a very small amount of money by today's standards, like $150,000 of our own money, plus a little bit of backing from them and decided to go for it. That was really it. So when I first started, I know what everybody knows in the beginning, which is nothing and just did my best. I mean, my main job was getting tacos and things like that.

And, but where'd you come out of? You were straight out of school or you were doing something else? So I was a biochemistry major with focus on neuroscience and physics. And my intention at the time was to become a surgeon. So what I did is I worked in surgical wards. I knew several surgeons for many years at that point, even already. I worked in neuroscience at this place called Beckman Institute at University of Illinois in Champaign-Urbana. And that was the plan. And then I, for logical reasons, had to sidetrack, got a little bit involved in finance with the intention of continuing down my physician path, and then was just so successful way more fast than I anticipated that it really just a couple hundred grand at the time. Plus, eight years of residency, I wouldn't make any money until I'm like late thirties. And I was already in a situation where I could make money from that accelerated period in the present. And it's not that it's all about money, but I also didn't come from any money. So the idea of having any discretionary money

was just outrageous to me. The idea that I could afford to buy something that I didn't immediately need was crazy. So it really just made me think it through. And so I decided to pursue a career in finance instead. And options is the world where you can, if you're good at it, you can do really well. And you also don't need to work 95 hours a week like a venture capital guy from Goldman or something like that. Not to mention a surgeon. Exactly.

Or as they're training. Wait, so you were making money trading off the floor? Where were you trading before you went to school? So my first job was as a stockbroker and I did it just out of school. And it was one of those things where a stockbroker is very linear of your income to your effort. So you're basically a salesperson and you try to convince people to do what you tell them to do. And I was good enough at that to make better money than really any of my peers, which I cracked six figures in 1995. And relative to my peer group, guys that were graduating from very good schools making 35 grand a year. And that was big money.

I just was able to do something that I didn't think I could do. So I really just reassessed the whole situation. And then, so your Susquehanna guys said, hey, this guy's smart and he knows a little bit of finance, get in here. I think, I don't know. I think they thought I was smart enough, I guess is probably a better answer. Smart enough. Yeah. Smart enough. And this is one thing I've hired a lot of guys. I've hired over a hundred guys and you really can't teach ambition. You can teach math, you can teach options, knowledge, you can teach all kinds of stuff. But I've had guys, and this is a tangent on a tangent, that are genetically more qualified to trade for me than other guys.

But the guys that just really wanted to be there almost inevitably have been more successful than the guys that maybe had a little bit more standard equipment upstairs. And the guys who just had more of a burning desire and more ambition tend to be more successful. And I think that was part of why the guys asked me to join them did. And who was it? The Bear Stearns guy or someone that ilk was, he wanted PhDs, poor, hungry, and driven. Well, I think that was Gordon Gekko. I think he stole it from, maybe it was Salomon Brothers, but one of those firms. We'll look it up. Put it in the show notes. So give us some of the stories from the trading players. So these guys start, you're there, you're actually in the pit.

What pit were you in? My first pit was Sears. And I went into Sears because the guys were the most nice. So it's a lot. A lot of new traders go to that pit. We put all of our new guys into Sears because some of the best pits, the guys were vicious. They would just blast you every opportunity possible. And Sears, the guys were just nice, cool dudes. And you could kind of

stroll in there and they wouldn't welcome you, but they wouldn't haze you as hard as some of the other pits. And typically when you walk into a pit, think about it like there's a pie sitting on the table, right? And you walk up with a fork, you're like, hey guys, can I have some too? And they're like, no, get out of here. So exactly. Nobody's going to invite you to have some of their pie because the pie isn't going to increase just because you're there. So usually the pits where the biggest helping of pie was at were the most aggressive about getting you you're there. So usually the pits where the biggest helping of pie was at were the most aggressive about getting you out of there. And they chased away a lot of guys. And so for me, I started in Sears and they worked my way up to, at the time, Coke,

symbol KO. And there was also AT&T. And then I ended up... There's actually a good picture I have, which they took for the CBOE annual report or whatever else. It's me, Pete Najarian sitting right next to me, standing right next to me. And we're in the front of the AOL pit, which at the time was the hottest name on the planet. And that was when I was trading real size and we could actually kind of move around. That was a luxury that I didn't even know I could do. Once I had enough status as a floor trader, I could like walk into a pit and not get hazed anymore because they knew I wouldn't really just be an idiot and just soak up bandwidth. Yeah. That comes back to our earlier theme of like the limits to arbitrage. Like why didn't the sharks come into the Sears pit? You think they'd just walk over there and take advantage of all those nice guys? Because there wasn't as much edge. Sears paper

wasn't all that great. What was the other name? Oh, it was Dow. Not Dow Chemical, but Dow Corning. And the biggest trade in that pit was when they had a judgment on breast implants. Because this is the reason that in the US, silicone breast implants went away for a long time is because there's this gigantic lawsuit. And that news came out one day in the pit where they basically said that silicone's fine and the stock went crazy. And there's a lot of opportunity for the next week or so. But other than that, I mean, Sears is like, didn't really trade much. Yeah.

And you're trading how? So you're filling orders for brokers or you're trading your own account? Well, you're trading how? So you're filling orders for brokers or you're trading your own account? Well, you're a market maker and you're doing both. You're not filling orders for brokers. A broker, what they do is they initiate orders from somebody else. So say for instance, you're a pension fund and they have an account at Goldman Sachs and you say, okay, we've got 10 million shares of Microsoft and we want to buy 10,000 foot spreads. So what they do is they call up the Goldman broker that represents that paper on the floor. And then the Goldman broker will walk into the Microsoft pit in that example, or Sears in my example, and say, okay, I want to do 10,000 spreads. What price can I get these spreads done?

And what else? Well, how can I get this order filled is the point. And is everyone salivating when that guy walks into the pit? No, not at all. So, I mean, that's actually a big part of trading in general is knowing, you know, when the counterparty is right or wrong. And that actual mental process is part of when you go from being a market maker to more of a trader and trying to figure out what is their point? Why are they right? Because you sit there and you're like, okay, I'll buy a bunch of options. I'll buy a bunch of options because they're selling them. And at some point you think to yourself, well, maybe volatility is too high and they're right. Or maybe they have a

directional opinion, or maybe there is a breast implant news announcement that has been leaked and people know about it. I mean, there's all kinds of reasons that people want to do things. And it's really not that different today. It's a little harder because you can't just pick and choose the brokers, right? And the brokers don't tell you what they're doing. They probably don't even know. And if a guy is always right, then it's just as useful in the opposite, right? If somebody is always wrong, it's just as good as being always right. You can just bet against them.

Yeah. I asked some of these funds that trade these esoteric stuff with the banks, French banks, and take them to the cleaners every three years. Don't you run out of suckers, basically? If you keep printing money on all those trades, you know, that's just it. So, you know, if you look at some of these banks, typically who are the traders at these banks? It's usually junior guys that don't fully understand the spectrum of risk. And it's not so much that you can beat up the same guys again and again, it's just the new guys. Right. There's new guys. They just move on. So those guys either get fired or-

They lost the bank a billion and got fired. Yeah. Right. Exactly. So trading with banks is some of the best paper that was ever there. So a few definitions. So paper, that's just, as you said, this guy's coming in to do 10,000 put spreads. That's the quote unquote paper. It's just an order. Say an order to buy options or sell options, whatever. And then as a market maker, so that person comes in 10,000 put spreads as a market maker, what are you thinking to do there? So if you pull up on your Robinhood app,

what is the price of a Tesla call? And you'll see a market, like $50 bid at $52. Well, who comes up with the $50? Why isn't it 49? Why isn't it 40? Why isn't it 90? Somebody has to make a decision as to what is the best price that they're willing to pay for these options or the best price they're willing to sell these options for. That person is making a market. They're creating a bid offer spread where you can buy and sell. And that's what a market maker's job is to do. And their general function is to try to buy on the bid and then hedge off somewhere in the middle or sell on the offer and hedge off somewhere in the middle. And they're not really trying to wail on the client or the customer.

They're trying to just make a tiny spread as often as possible so that they can make a good living as well. Right. A hundred times a day, just take out a penny. So on that type of order, you're talking about what was the spread there? A couple bucks? Big trades usually get shopped really hard. So realistically what happens is if a guy has 10,000 Microsoft spreads, they're like, okay, I have 10,000 spreads, 8,500 of them are going to cross on the Phylex and we have 1,500 left we can do right here. We're going to do them for a quarter. Who wants some? The other side of those trades is guy comes in, is willing to pay anything for a little biotech name. And then you know, they're going to have an FDA announcement or something like that. And that paper is very... That trade is very likely to be right in their way.

So you're very skeptical to trade with them. Right. And then, cause you can't even get the hedge off, right? So talk a little bit about that of the market maker. So you're saying, cool, I'll fill your 10,000, say it all came to you. Now you have to delta hedge it basically to keep yourself flat. So I have one really good trading story about that. I was in a relatively small pit and this was when I was a pretty senior trader. So I knew

what I was doing. And Goldman broker comes into this pit. There's only like six guys in this pit. This is a very new, this is during the internet craze. And I forget exactly what the price of the stock was. It doesn't really, let's just make it a hundred dollars. It wasn't a hundred dollars. Let's just say it was a hundred dollars. Guy comes in and he's like, okay, what's your market in these calls? And it was a very high vol name. And let's just say it was like a $20 bid on these calls. He's like, fine, I'll sell you a hundred at $20. I'm like, okay, well, this is a very thin name. I'll buy 50. And I try to get my head off. He's like, how are you coming out? Meaning like, what's your new market after this trade has just already commenced? And I said, well, I don't know,

$18 bid now. I just paid 20. I'll pay 18 for the next round. He's like, fine. I got 100 to go. How many do you want? I'm like, 50. He's like, okay, fine. How are you coming out? I'm like, really? So you still want to sell me more? And I'm like, fine, I'll pay $16. And now I'm trying to get my hedge off. The balls are in the air. The eggs are on the stove. It's busy. And he's like, how are you coming out?

I'm like, how many do you have? He's like, I got 500 more. I'm like, $15 bid. He's like, sold. Shit. Now I own them. And I'm like, okay. And he's like, how are you coming out? I'm like, $5 bid.

And he's like, how many? I'm like, 500 like, $5 bid. And he's like, how many? I'm like, 500. He's like, sold. I'm like, holy shit. And this is under parity at this point. So this trade on paper is ridiculously beyond amazing. By the time I was able to get my hedge off, it ended up being a breakeven trade. But I had millions of dollars of theoretical edge that was evaporated in 30 seconds, 40 seconds, because he was just right. He knew the stock was going down and the options market was the place he was trying to express that opinion. And I had no idea. So he was selling the calls. He was selling the calls. I was buying the calls. I was trying to sell stock and I was not able to get any shares for multiple dollars. And how does that work in that CBOA pit actually? So you're trying to sell

the stock. Do you have a clerk there that can hammer it out? Like pre-computers. So there was three real ways that you did it. You did it with a broker that was usually physically located by you, a clerk that would translate, that would act as an intermediary, or you would have a computer. And we had all three, so whatever. Yeah. When I worked at Board of Trade, I was in the bond pit as a clerk and my broker was a futures broker, but I was staring at the options pit. So all their delta edging, right? I was just the guy of like, buy 200, buy 400. Right. And so I always like to talk about this for the people who weren't back in those days. So you knew how many you had to hedge,

you had a little sheet in your pocket, right? Yes. All these option guys had sheets in their pocket. And basically that's telling you all your Greeks for however many strikes down. So what the Sheets did was it would basically act as a matrix. So if you said that Apple didn't really trade back then. It was basically bankrupt. Most people don't realize that, but Apple was almost bankrupt in the 90s. But say it was AOL and the vol was 30. Well, you'd run a list of strikes and prices at a 30 vol. And then you'd run a different list of strikes at 29 vol, 27 vol, 25 vol, or 35 vol, 40 vol. And if it got too far out of range, you literally would leave the pit, go run new sheets, print

them out, come back down, and then try to re-engage the marketplace. So it's all vol-based, wasn't price-based, or it's both? It's a matrix. It's both because vol and price are algebraically fungible. So you can say that a 30 vol equals $1.50 on the option or $1.50 on the option equals a 30 vol. And once you do it enough, they're interchangeable. So how many times did you have to go off your sheets? You go off your sheets for the best trades. So the best trades come into you and what happens is 90% of the time, you look at your sheets and you get a good idea where things are.

You don't use your sheets that often after a while because you just kind of instinctively know where things are. And then what you know versus what the market is offering you in data. Because say, for instance, the guy says, I'll pay a dollar for these options. That equals 30 vol. But you say he wants to change that. Then you have the choice to either trade at his price or not because everyone around you is going to. So then you're put in a position to kind of noodle this stuff through and where is it in the spectrum of the rest of your book as well. And that's really when you go from being kind of a market-making monkey, which is not all

that easy in the first place, to really being a small portfolio manager. Because if you're trading everything in your pit, let's say that's 10 to 20 different names, you already have a portfolio of those 20 names. And then you have to figure out what is the correlation between AOL and Dell and Dell and at home or Lycos or whatever else. Those are real names I traded. Yeah. Did you do any pets.com, any of those guys? So pets.com actually was in Sears. So that was when I had a guy in that pit and I didn't trade pets, but he did. And that was just one of those stocks where everyone knew that it wasn't really a stock. It was like three dudes in a closet with a dream.

And it was like a $90 stock. We're like, no way. And so the funny thing is actually from that era, I had a physical trading ticket of my stock fill and I had bought 10,000 shares of Yahoo at $499. And the receipt was still in my breast pocket. And I didn't find it until years later when Yahoo was like, you know, 40 bucks or whatever. Yeah, exactly. And I wasn't trying to get long that much. Yahoo was a hedging trade, but it was just very laughable to see that years after the fact. Where you should frame that, put that up. Kind of where it is.

And talk about that real quick. That's interesting. I've never actually knew that. I was a board of trade guy, not a CBOE guy, but I'm picturing there's pits for every stock, way too many. You'd have to have way too many pits. Right. Right.

So how many stocks were in each pit? So the CBOE management tried to put like one or two super busy stocks in each pit. And then it would have eight or nine somewhat boring stocks. And every now and then, one of the boring stocks would have a takeout or become hard to borrow or something like that. And so usually, as I'm saying, you had 10 to 20 names in any one given pit. And that is really the basis, the bootcamp for becoming a portfolio manager, because that's really what you're doing. Right. So dig into that a little bit. So you have all these positions. You didn't have to. Were there guys who just stood in that pit and just traded one name to keep it simple? Yes.

So your brain started going, hey, I could trade all these things in a little mini portfolio. But to your point, you're way off your sheet then. There is no sheet for that. You have to, you're mentally doing that math of like, okay, I'm long this much AOL. I'm long this much. I got to Delta hedge these. And then it's all fungible in your head of like, okay, if I sell some AOL, I can hedge these other calls that I bought.

Absolutely. So if you know that there is a relationship between AOL and XYZ and that relationship is usually 80% or maybe 120% in beta terms, then you have to figure that out and you have to kind of know where your risks really are and what happens if they all go down? What happens if they all go up? What happens if your longs go down and your shorts go up? Happens all the time. So when correlations change, that can screw you, right? So that's the biggest risk there. One of the biggest risks. But two, how, where in this, what years were these? And when did you start to move to the computer to do all this work? So this is the mid and late 90s. And then we started using computers pretty early on.

I only used paper sheets for a little while. And just by virtue of chance, when I showed up is when computers started to exist on the floor because you needed the connectivity as well. And then we also had these little, they were called raise trades, which was like a retail execution order system or whatever else. And trades would just hit you called raise trades, which was like a retail execution order system or whatever else. Trades would just hit you on your marketplace, which is actually the real birth of high-frequency trading. High-frequency trading was born out of automated trading at the CBOE. Those two things are very interconnected. But being able to hedge out your deltas

at a computer, it happened relatively fast in my life. And then after I started trading my whole pit and we started backing other guys, I started to try to like lord over other pits. You had a guy in the pit next to you like, okay, how's your AT&T position doing, Bob? How's your Microsoft position doing, Steve? And you kind of figure out where everybody is in the matrix of things. And you realize that, well, the Goldman broker is selling me options in AOL. The Goldman broker is selling Microsoft options to Bob, and the Goldman broker is selling options to Steve. Maybe vol is for sale.

Maybe I should lower my bids. And that's when you start to become like, that's like 102 level portfolio manager, maybe even 103 level. And how did, but so you're just using the computer as a tool at this point. It's not basically informing you, right? It's just a tool. It gives me no information. Right. So how long after that till nowadays the Delta hedging can happen automagically, right? Yeah. All my Deltas, they're done instantly. How does it go? How do you start to get a big picture stuff?

I didn't really get big picture stuff until I started lording over the whole firm. So if we had a guy in every pit, we had a guy in every pit in the CBOE. We had guys at the Board of Trade. We had guys at the Merck trading Euro dollars. We had guys at the NYMEX. We had guys at the COMEX. And then as you become the hub of all this information, you start to have these big picture ideas. And that is where the ideas and the experience really started to coalesce for me as to big picture ideas. Fall is for sale. Interest rates are moving. What does this mean across the board when these things happen? And that's quite relevant to my current job, which is why I've been daydreaming about running outside money, I don't know, since 2003. Yeah. We'll get to that. Sorry. I'm going to stick on the... So you went to basically a prop model, right? So you had all these guys inside the firm, all their P&Ls are syncing up, all their risk is syncing up. So

that Goldman example, you're seeing them, they're selling in a whole bunch of names. Maybe they're even selling in rates of all and whatnot. So is that get put into the computer? Do you see it as an alert or you're just taking that into your human brain and saying, okay, this is happening. I need to reposition the whole firm this way. So it was both. At the time we cleared a company called Pax and then we also had Spear Leeds. And the way they shocked, they would give us paper risks. So it would say, okay, you had X amount of capital, now you have X amount of capital and here's your risk on different matrices of shocks. And so we would kind of comb through these physical paper printouts and we would say, okay, well, down 10%, vol up 30%, we are at this much risk.

And then you keep this stuff in your head because if you don't, nobody will, right? It's just your job. So you start to get a really good picture. And when you stare at the same stuff all day, all the time, you get pretty accurate at it. And whether Microsoft vol goes up a point or two is something you don't really remember, but unless you have a huge position in it, but the overall Vega of the book, the overall gamma of the book, the overall theta of the book is totally relevant. And you're looking to, you know, mitigate that risk all the time. And so did you say, hey, we're going to, I'm going from, but this was the same firm that you had joined up with? Or did you start out and say, I'm going to start my own prop firm? No, this was my own prop firm. I was an equity partner in this firm. Got it. So to me, it's like, when did you go from,

all right, I'm going to be a trader. I'm going to make a lot of money for myself to was there a conscious decision there of like, hey, I'm going to scale this with all these other guys? Or was it more of an intellectual exercise of like, hey, I'm getting all this other information. We need to put it together. No, it was more rudimentary than that. It was more like, okay, well, if I can make X amount of money in a pit in a given year, then if I have a guy next to me, maybe I can make two X, maybe even more. Yeah. So then you can extrapolate that to, you know, 30 guys in 30 pits. And all you really have to do is cover the, you know, the seat lease, which at the time was like 13 grand a month or something like that.

And then you, if you have the excess capital and you have, you can take on the extra risk, you decide to back somebody else. And then one becomes two and two become four and four become eight, et cetera. Right. But which Stafford, the aforementioned was doing the same thing at the same time. A lot of different groups. So how did you differentiate yourself there? Everyone's got the same sheets. Everyone's got the same knowledge, right? So it's funny. I've done a handful of interviews and nobody's ever asked me that question. And the real answer is way more disappointing than a lot of people want to hear. But I had the secret black box.

Right. There is no black box that I know of. The only real black box is high frequency trading. And it's almost literally a black box in the sense that it's faster logic. But the quality and the timing of information is how we did better than our peer group. And what we did is we got to know the brokers. We have to understand. And we would keep track of where the information came from and how good was the information or was it counterfactual information.

Some brokers at that time constantly had cheaty paper. Cheaty meaning they were trying to cheat the marketplace. They had insider information or something like that and their trades almost always went their way. What does TD stand for? Cheat. Like he's cheating at cards or something like cheaty. Cheating. Cheating. Like cheating paper. Got it. C-H-E-A-T-Y.

I thought you were saying like TD Ameritrade. No, no. Actually, TD was still Toronto Dominion Bank at the time. Exactly. Which ended up buying Stafford, right? Did they buy Stafford? I believe. No, they bought all of Stafford, I believe. I didn't know that. I kind of forgot it.

So brokers that always have paper that cheats is just as useful that brokers that never have paper that cheats. Actually, it's probably more useful. So what you do if a guy wants to buy a thousand options, you sell them 50 just to keep her happy. And you go and you buy as many shares you can get your hands on. And maybe you're right, maybe you're wrong. But if he's always right, you're probably going to lean into that just right. And who cares if he's actually cheating, right? If he's always right, it doesn't matter why he's always right. Just get in front of it. That was the whole concept behind the Goldman rule, going into commodities, right? We know this flow is coming at this time every month, get in front of it. Right. Exactly.

Which is interesting of like insider trading cases. Do they ever come down? Were you ever disposed or anything of like, Hey, we're coming all the way down to the market maker level? I had one case where I was the largest shareholder of a stock that didn't work for the company. And I had some law firm call me up and be like, hey, do you want to go to court and testify? I'm like, no, no, not at all. It's like, well, how about if we put you up at a $5,000 a night hotel and all these other things? I'm like, okay, fine. And this is actually a pretty interesting point that I think a lot of us older people come to. So I find myself in federal court. And the other side was three guys. This is in Boston. So it was all older guys, gray haired professor types, guy from Harvard, guy from MIT, another guy from Boston College. And they're all talking about me, but not to me. And there's like 50 people in court. This is not like, there's not a jury trial, right? This is not jury trial. Are they the expert witnesses on option pricing?

Yes, exactly. So this is such a seminal point in my life and it's really guided me ever since. These guys were all talking about this stuff. And then my lawyers asked me, what do you think? Are they right? Are they wrong? I'm like, I can tell you that these guys are wrong and I can prove it with math and graphs in 10 seconds. And they're like, all we need to know, boom, that's all we need to know. And I'm like, so, you know, you can study skiing on paper for a thousand years. You can say, okay, well, if the coefficient of drag on your, your wax is X and your, your, your, your edge sharpness is Y.

And the, you know, the temperature outside is Q. And you can come up with all these reasons why you should be able to ski. Then get on skis and show me how to do it. Not so easy, is it? And it's exactly the same thing. And that has kind of guided me for so many years, which are people that are supposed experts in something are not practitioners. And sometimes they are, sometimes they're not. But a lot of times people that are supposed experts in something are not practitioners. And sometimes they are, sometimes they're not. But a lot of times people that only operate in the domain of intellect or theory are often terrible practitioners. Yeah. Yeah. I mean, we say that all the time. You get a super smart coder, quant, but you put them in front of live trades,

real people's money, and they're like deer in the headlights. Absolutely true. It's not supposed to work this way. So you have all these guys. What was the peak number of guys in the prop firm? What was it called? Third millennium? Third millennium trading.

I don't know because we never actually did a little clicker count, but we probably had at our largest time probably about 65 guys, but I probably hired 100 and something over the time period. So 60 in pits actually trading? In other words, like 65 guys or so on payroll every month that we had to take care of. But that also each had a P&L? Yes. Yeah. So were you ever thinking like, okay, I want to put uncorrelated return streams together, or they're basically all doing the same trade, just in different names?

Definitely number one, definitely uncorrelated strategies. So what happens is, say the VIX goes from 30 to 15. Well, the volatility in all of the pits will go down. And so that's when, again, this is the next level of going from being a market maker to a trader, to maybe a prop trader, to being more of a real portfolio manager, and then kind of a guy who runs a firm. And you start to see all of these things and you start to connect the dots as like, okay, well, if the paper's really hot in Euro dollars, what does that mean for my Goldman stocks? Well, actually Euro dollars and Goldman do have a relationship because the shape of the yield curve for Goldman's lending program is completely affected by interest rates and interest rates are being borne out to bear right now in Euro dollars. Okay. Well, what part of the Euro dollar curve is most relevant to Goldman?

Well, it's the front end. Okay. Well, how much front end paper does Goldman have? And you start to suss all these ideas out. You're like, okay, there's a relationship and we can probably make a trade here. But in real time or over a course of weeks or you're sitting down with all those traders and saying, hey, this is what might be playing out? In real time or by end of day. So you look at the Eurodollar paper at end of day, you're like, okay, well, what's going on in Eurodollars?

Okay, well, they're implying an interest rate rise or whatever, right? Or maybe a more accelerated interest rate rise than what the marketplace is currently pricing. Okay. Well, if interest rates go up faster, what part of the yield curve is this most relevant to? And again, you have to figure it all out because interest rates are irrelevant to all kinds of things, everything. This blows my mind because, right, you're on Twitter, you're reading blog posts, and you're like, oh, this euro dollars are signaling this. And you think about a trade for a few days. Like, by the time you've read that on there and think about it, it's already been, right, there's market makers who have been there for a week already. Absolutely.

Yeah, that's fun. And so to me, it's like, this is this new concept of pods, right? Of Ballyasney, all these other groups of like, hey, we're putting pods of traders together. But Mark, prop firms were doing this long before it became a hedge fund. And we did not invent that at all. So we kind of knocked it off from Susquehanna, which is kind of the DNA that I you know, I have a trading DNA. And I don't even really know who did it before Susquehanna, maybe O'Connell. Maybe O'Connell. I knew a guy named O'Connell. O'Connell or Spear leads. Actually,

the O'Connell guy was the brother of an actor that was, he was Robin in the Batman movies. I forgot his name. He's the next to me. Maybe, I forgot. But anyway, it's funny how the memory works. He was the guy who stood next to me in a pit and whatever. There's their family up from Winnetka, but they're nice guys. But anyway, so you start to figure these things out. So that's also kind of the genesis of my fund, which is once you start to see these things out. So that's also kind of the genesis of my fund, which is once you start to see various trades, like say you have a Eurodollar guy and you have a bond guy, well, those two things are related. And then you have a guy that trades,

I don't know, cattle, right? I knew a guy that traded cattle. He was literally a rancher from Texas. The guy that would ride around on a horse and figure out cattle stuff. And then his information was as contemporaneous as you're going to get in the cattle world. And I thought to myself, as I got to know this guy, I'm like, I will never know more about cattle than this guy. So if you're trading against this guy, you're probably going to lose money, barring luck. We have a few funds that do cattle or hog trading. And I asked those PMs, there's one right answer. I'm like, how come Citadel or Susquehanna, someone doesn't go pay the same ranchers, you know, and get this information. The incorrect answer is like, oh, they're my friends and they won't do it. The correct answer is it's not worth their time. Like they could easily go do that,

get the same information. It's not worth their time. It's a limited market. And they're like, we don't need to do that. But so that was going to be one of my questions. Were these all option vol traders? Or did you have a guy who was like picking stocks or going outright long natural gas? We have never had, well, we've taken deltas and everything all the time. So if you have an opinion in natural gas, you don't have to express it in the options marketplace. I have always gravitated toward options because that's my comfort level. But also, I feel like anything you can do in the equity space or in the Delta One instrument space, you can do better or equal to or greater than in the option space. So I almost always go Delta One in options.

Right. Exactly. You can get both. Right. Exactly. Just put on a combo and poof, you own it. Or you can do some kind of a risky and you kind of sort of own it. Or you can buy some out of the money calls and you probably don't own it. But yeah, there are so many things you can do with options that you can't do with the Delta one instrument. And you can even mitigate your decay and all this other stuff.

Once you kind of suss it all out, like I said, to me, it's equal to or greater than the Delta one instrument, whether it be gas, lumber, Tesla, whatever. You've got this prop firm going. Did it become winner take all? Why did it cease to exist? Speed became an issue, high frequency became an issue? No, we kind of dissolved due to my business partner and I just going different directions personally. And that was it. So we had made a bunch of money and then I've never been able to make money like this, right? Sadly.

I wish I could now, but I don't know how. I've always made money in clumps. So what that means is that my P&L has been like- You know how many people make it like this? Yeah. People that are high frequency traders. Guys that trade cattle high frequency and they never lose money, but they can't scale that big. They have a 12 sharp, but they only control $3 million. The P&L that I've always, unfortunately, had to deal with is kind of an upward sine wave.

We were just coming off of a crest of a sine wave, and I was getting pretty bearish on my own expectancy. So I decided to take off the summer and the summer turned into a winter and winter turned into a year. And that was kind You always got to upgrade the technology. You always got to upgrade the, everything's going and you start to lose pace with the DRWs and peak sixes and all these groups that have somewhat unlimited resources to throw at the game. So that's true and not true. So what does the technology do for you? The technology enables you to do all the same stuff that you would do in a pit, but better. It allows you to access your trade more quickly. It allows you to analyze your risk better and more accurately. And it just basically puts a turbo on all of your same pit stuff. And the quality of the information that we got, because we were first looked for many banks. So say for instance, this pension fund in theory has a Microsoft trade and they pick up the phone. Who do they call? I was literally the first call on planet Earth for a dozen different banks. So just by virtue of me being that first stop on the information tree, the quality of information I got was par none.

You know what I mean? It was just excellent. So that was one of the reasons we were able to make money. And then once things became more and more electronified, the game changed a little bit. And then it changed a lot. And then it actually kind of reverted because speed is now more commoditized. Yeah. I've heard stories like the Susquehanna guys are just sitting in the pit and they have

bands that they're allowed to trade in, right? And they can't even, if it's like you were saying before, this guy wants to let me buy him for 15, right? They're priced at 25. They're like, nope, you can only stay within the band. I don't know. Yeah. So those guys, it was really like Timber Hill guys, which were probably the worst paper.

And Timber Hill is now actually Two Sigma because they were bought by the guy in Florida, Interactive Brokers. Yeah. And then Two Sigma bought that operation. But there are firms that are given parameters by the guy upstairs. And he says, okay, you can pay a dollar and you can spend $1.50 and nothing more, nothing less. And the guy's just like, whatever.

And if a guy comes in and says, I'll sell them for 50 cents. And he's just like, I can't do it. I'm like, fine, I'm all. I'll take everything you got for 50 cents. Let's go. And that discretion was great. Yeah. And just wonder like, why do those firms,

it's just, again, not worth their time. It's like, we don't want to get hung on something we don't understand, just trading this band. But this guy was telling me, it's like, they're robots. They're just trading, right? They're the human in there, but essentially they're a robot because they can only do this limited thing. That's exactly right. So what happens is,

if you look at the guys that run funds or run market-making firms or whatever else, are typically guys like me that had to really learn it and risk their own money. And if you look at the guys that were, Timber Hill guy number 63 standing in the pit, I have no idea what that guy's doing because he never really learned a skillset. He was just a device in which to get your business executed. My brain goes to the Ready Player One book and movie where all the guys trying to solve the game are like in the, right? They just have numbers. They can't do it. They had no soul. Going on, we're going to do a, listeners, we're going to do a second part to dive into the strategy because there's lots of good stuff here but this is all good on the back so somewhere

along there you got involved with get go um tell us what happened there what happened with get go and all that so um the guy that started get go used to work for me, us, and we lost a bunch of money. And I think it was like LTCM or the Russian ruble tie bot. I don't remember exactly what it was, but it was like 97, 98. It's a good life when you can't remember losing a lot of money, what it was from. Oh, yeah. It sucked because I remember, so we lost more money than we had on deposit. So at the time, well, we lost more money than our haircut needed. So our haircut was like 10 million and we had like nine. So we couldn't take any money out and we were on closing only. So this is the closest we

ever came to blowing out and this is the beginning. So we said to this guy, you're not fired, but we don't have any money for us or for you. So if I were you, I'd quit, but you don't have to quit. So he came back with a buddy of his and they were working on some basically electric versions of what other people were doing. And they pitched the idea of what ended up being GetCo to us. And we said, sure, here's some money. And that was the genesis of GetCo. And explain GetCo for the listeners. It became a big thing and then it sort of disappeared.

It's still out there? Getco is now Virtu, sort of, not really. So what happened with Getco is they made a lot of money and then they bought Knight after the Knight algo went nuts. Basically, it's an electronic market. Yes. I remember the exact meeting where my brain was blown up by Gecko. We were having a meeting after school one day and one of the guys said to me, he's like, okay, no, I've got a question for you. Quiz. What percent of Intel's total daily volume do you think we are? And I knew he wanted the answer to be high so he could feel good about himself. My real internal answer was 0.5%. So I said, 1.5% thinking I'm trying to make him feel good.

He's like, 17. No way. No way is it that high. And that was when I was like, okay, what are you talking about? And that was when I really paid attention to, paid attention to the Getco idea. And then, you know, we tried to do more with options and options thing was always a little bit more difficult. And then as speed became more and more commoditized, you know, the Getco trade started to suffer.

And who did they, who did Getco replace? The specialists, the human specialists on NYSE or what, who did they disrupt? The specialists on the NYSE, the people that you see on CNBC, the DPM marketplace at the time, at the time it was called DPM. Then it went, moved to DMM, same, same, but different. It was basically the primary specialists that would take down paper in either stocks or derivative products, but that's mainly who that ruined. All right. Two more things on these glory days.

So CBOE, you were a CBOE guy. I was a CBOT guy. Then all the CME guys. Was there competition there? Did you like those other guys? Were you like, oh, those crazy commodity cowboys? What what, what was the vibe in Chicago back in those days between the pits? The, I had never had any real knowledge. I never even went to the Merck floor. I was on the board of trade for a couple of times. Um, the, the crazy salacious stories that you hear about floor traders are almost always the Merck guys. Um least to me. Those are the dudes that were running around with fast women or all those

stories that you hear that are maybe sometimes true. Well, it is the only pit, as far as I know, that the FBI had some plans in, so yeah. Right. Exactly. So I remember in this year's pit, a couple of guys first started talking to these dudes. One guy was a dentist. The other guy was some other kind of doctor. The other guy was a lawyer. Like, oh, these guys are actually pretty smart. They knew what they were doing. And the board of trade to me was maybe a little bit less intellectually robust than the CBOE. And then the Merck was like, I don't know, use car salesman dudes. That was my perception, whether it's wrong or not. And it could be totally wrong. That was how it was kind of at the time in my mind. I think I would back that. But would you guys ever all get together or co-mingle with them, like maybe on a boat? We had a boat in Chicago and we had a pretty

nice boat and then we ended up upgrading it to a pretty big boat and a lot of traders. We would have people with 150 people on my boat and it would be nuts. And we would have people from all over the world and come visit. And actually we took that same boat to Europe and to New York. We would have a party in New York twice a year because the boat would go from Chicago down to Florida and then back. It'd have to go over the St. Lawrence Waterway. That's where my finger's going up You'd have to go over the St. Lawrence waterway. That's what my fingers going up. And then I used to go to the St. Lawrence waterway down through New York. And we'd have a party on the boat in Manhattan once in the spring and once

in the fall. And how, how big of a deal with it? I've heard other guys talk back in the old, right. It was like, you're taking those brokers to Gibson's. You're taking them out on the boat, right. Like to get that order flow. That was how business was done. Yeah. The brokers aren't dumb or nefarious, right? They just want everything else being equal. They want to make the most amount of money for

themselves and for their families. So all they really want from you is to give you good markets and give them fast. That's their incentive. And everything else being equal, they really want from you is to give you good markets and give them fast. That's their incentive. And everything else being equal, they just want you to be a cool dude. But the idea that there would be worse pricing or slower pricing is antithetical to their money. So it doesn't matter how many times you took me out to Gibson's. If you give me a bad fill or slow fill, you're out. Exactly.

Exactly. So what you really have to be able to do is be good at your job. And if you can be cool on top of that and show them a good time, all the better. But being cool or throwing money at a stake at Gibson's, it's a fart in the wind. And then tell us one good story about a guy whose house got repossessed or something of that nature when the accounts went the wrong way. Well, we got a million of those. I'm trying to think. I mean, I know a lot of guys that blew out and I think I'm blessed in the sense that I don't ever get joy out of someone else blowing out. Cause I always feel like I'm next. Yeah. Um, so I never really, uh, you know, like that stuff, but I can tell you one story that was pretty funny. Um, you know, remember the old song by

Janis Joplin, uh, Mercedes, my old Lord, won't you buy me a Mercedes Benz? Yeah. Yeah. So, uh, there was phones in the pit and this isn't the A in the aol pit and um one of the guys took a call from his wife and he was yelling at her on the phone but everybody could hear it because you're standing like three inches from everybody it was a cell phone you're saying there's like a physical corded there's a physical corded phone in the pit so you know phone rings that you know this guy picks up the phone and his wife had just crashed their mercedes-benz and the rest of the pit figured this out from the context of his end of the call. And they all started singing the song at the same time. And it was just absolutely hilarious. This guy's like, shut up.

My wife just crashed my car. But yeah, in terms of blowouts, I mean, those stories are innumerable and they're all kind of sad because those are people with families and all that other stuff. And that happens. I think one of the biggest things that people don't, they want to believe that everyone down there is crooked or that everything is like just these Coke filled orgies or whatever else. I never saw anything like that. I never knew of any insider information. I never knew of any Coke filled orgies or anything like that. Most guys are just dudes that want to make a living. Yeah. And to me, the best thing of it was you mentioned some of these CME and CBOT guys aren't the smartest tools in the shed, but it gave them a chance, right? It's almost like crypto today or whatever. Like, hey, you didn't have to go to the Ivy League. You didn't have to know all this stuff and get perfect scores on your test.

You could go down there, have the drive and make a killing. You could be standing next to a guy that has a 1400 on his SAT and went to whatever college and you barely got out of St. Vider somehow. And you could be standing shoulder to shoulder with this guy and maybe you make $10 million that was the dream. Okay. We're cutting part one there and we'll bring you the rest of all Noel's great stuff in part two. Thanks to Noel, thanks to our editor extraordinaire, Jeff Berger, and thanks to all of you for listening.

We'll be back next week with either Resolve or part two of Noel. I haven't decided yet. You'll just have to tune in and find out. See you next week. You've been listening to The Derivative. Links from this episode will be in the episode description of this channel. Follow us on Twitter at RCM Alts and visit our website to read our blog or subscribe to our newsletter at rcmalts.com. If you liked our show, introduce a friend and show them how to subscribe and be sure to leave comments. We'd love to hear from you.

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