It seems to me like the crowd here is quite different from the one at Wilmott or Nuclear Phynance, another two reputable forum for finance industry. Those forums are definitely filled with quants, who are no stranger to terms like "Geometric Brownian motion" or "Itô's lemma" or "ways of deriving the Black Scholes formula like risk-neutral valuation, martingale approach, replicating portfolio etc". Question is, any of the *successful* option traders here could be qualified as a quant? (I'm trying to determine the correlation between quant knowledge and finding an edge in options trading).
I dunno if I'm particularly successful...but I am certainly a quant. I have a degree in CS and mathematics and I've taken a series of classes on computational investment and risk. I trade volatility generally but I make directional bets when my models say so. Options are often thought of like buying and selling insurance but unfortunately the retail investor will have trouble realizing this mental model of options. Insurance companies have the benefit of investing the proceeds from the sale of their contracts immediately - we do not. It is helpful to know the pricing models so you understand the relationships the greeks play in the valuation of the contract. For a retail trader this is about as advanced as you can get in these markets I think. Majority of my trading comes from my knowledge of probabilities. I've used stochastic calculus to derive certain things like "probabilities of approach", but to be honest most of these can be found via monte carlo methods under certain assumptions. Monte carlo methods are far easier though not as "strict". If you're doing statistical arbitrage on options contracts I'm guessing you need DMA to really get the best pricing. For industry folks with more money and more collective brainpower there is opportunity to develop and refine pricing models. There's more opportunity to develop arbitrage and market making strategies using these refined models. For the rest of us, the knowledge is very useful but what you can actually apply from the retail side I think is very small. I'd be very interested in hearing from anyone using more phynance in a retail setting. Not specifically how but more around what you are doing and what kind of capital/market access you have.
How can you (we retails) be successful when trading against counter parties who are MM or professionals (institutions) who have those sophisticated tools? And I don't think there are enough of us around to trade against one another.
Your objectives are different so it's not competition. The quants generally aren't trading a view of the underlying. Many quaint shops have had terrible years. You are doing research and (hopefully) looking at some metrics that make you want to trade. Just the way MM objectives are not opinion driven - you are trading because you have a view. If in your heart of hearts you think you're competing with them and getting poor results then you Should either change your style or walk away.
They aren't trading the same way, with the same capital, and the same goals. Your sentiment isn't exactly uncommon which is unfortunate. But without some knowledge of how the pro's are trading it does indeed seem hopeless to try as retail. Just because their edge is in the spread, doesn't mean all edges are gone for example. There are some inefficiencies that retail can take advantage of that are much harder to take advantage of with large sums of money behind you. A major (and often forgotten) benefit of being retail is how quickly you can move in and out of trades. Professionals don't have that luxury. You can use this to your advantage. Sure you are going to have a real hard time trading big lots or performing arbitrage when your order flow is being sold and your execution is way worse. But there are many other strategies you can use to be profitable in retail. You have to play the hand you are dealt, and when you are dealt that hand at a different poker table than the ones the professionals are playing at, there has to be advantages you can take advantage of.
I get it. What you said is my counter parties make their money not on my specific trades but some other combination of trades so we can both be profitable? My question though, is no matter what their methods, retails or professionals if we all are profitable, who are we taking our money from?
OK, as I asked Mr. ajacobson, if we are all profitable, professionals and retails, because we trade different instruments, approaches..., where is the money coming from?
Each other. Options being a zero sum game is debatable. On one hand every dollar you make they lose, but they can also hedge their position. Eventually it becomes an argument into absurdity - it just depends on where you draw the loser line in the game. It should be obvious to you we cannot all be profitable. I don't think our implication is that we are. I think what is happening in your model of the world is the confusion between how retail operates and how professionals operate. Market makers for example make money on the spread. This is money you "lose" effectively by purchasing options from the market maker. Are you unprofitable? Maybe not. However, you start out a little down because the market maker got their cut via the spread. They are not competing with you, or any one else in retail. They are really only competing against other market makers via tighter and tighter spreads. These people are basically entirely out of your equation. Prop shops swing huge lines that influence the market. They make money similar to retail, though certain strategies like playing weeklies for example are likely outside of their utility because of the difficulty of getting into and out of a trade that large quickly. These guys are more than likely using options as a hedge. They may "dump" money into the market, but it's money well spent to hedge an otherwise risky underlying position. HFTs are making money by taking advantage of small pricing discrepancies on the market on the lowest possible timeframes. In reality, I would bet many of them make a sizeable chunk of cash from taking payment for order flow and "accidentally" trading in a way that is advantageous to them given this information. To be honest, I'm not totally sure about the HFT game in options. Retails by and large make money on larger timescales. Soaking up the dollars coming out of the contracts on a weekly or monthly basis. Money is "lost" to the market, and taken in large amounts from the market as well. It's impossible to compete with HFTs and prop shops on this so in general retail options traders are swing traders that are trading the dominate trend, or events. My point with all this is that we aren't all profitable on every trade. This fuels the market. Its entirely possible to post a green year having given the market a sizeable chunk of money. Some people finish in the red giving more than they took from the market. This is the way these derivative markets work.
Are you asking is it zero sum? Probably many products are - as a rule, a stock is the worst example because most of it is unhedged long. Take the example of buying a call. You buy a call as a directional bet. The MM who sells you the call buys the underlying and buys a put. Your long the call and the stock goes up $20 - the MM with the conversion +Stock+Put-Call makes a $.10 on a 20$ move. You make - for purposes of this example, $19.90(assuming no commission and no dividends) and the MM made a lousy dime. Yet you both got the outcome you hoped for. Is it always this clean - no of course not. Is there a short for every long - no of course not. Must long stock is unhedged and it's a pretty simple equation. Wealth is created when the market goes up and lost when the market declines. Hedges change the equation and both sides of a hedged trade can make money and be happy. Do customers ever go bust - do MMs or dealers in general ever go bust. What are the two biggest lies in the trading industry: I HEDGED and I'M PERFECTLY HEDGED. Ask yourself this question: When the market corrected in 2008 - who made the money that was lost? A handful of hedge funds did well, but the losses were staggering. Any good tales about customers and firms going bust in recent weeks? The worst role in that equation will be the clearing system and its constituents. The longs will get paid and the losses will eventually be covered by a brokerage house that will lose a ton of its shareholder equity, but the clearinghouse will cover everything for now. Zero sum, but not between the longs and the shorts.