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!
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Check out the complete Transcript from this week’s podcast below:
Options Alchemy: How Bernie Yu of Patronus Capital Transforms Market Making into Strategic Investing
Bernie Yu 00:07
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.
Jeff Malec 00:24
Welcome to the derivative by RCM Alternatives, Send it!
Bernie Yu 00:27
Hi. My name is Bernie Yoo. I’m the co founder and CIO of PATRONUS capital, and we’re here to talk about options and investigate on The Derivative.
Bernie Yu 00:47
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.
Jeff Malec 01:00
Which suburb for all those Chicago folks?
Bernie Yu 01:03
I am in Winnetka, 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.
Jeff Malec 01:19
I think someone wanted to buy it and make it like a Airbnb, right? That would have been you could stay there,
Bernie Yu 01:25
yeah, that would have been neat. I think the council has put a fair bit of regulation around it, though. So
Jeff Malec 01:35
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.
Bernie Yu 01:42
Yeah. So I, I went to school in 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, trying 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 in 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 optivo, and that was in the 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 vol 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
Jeff Malec 03:24
will. And so you’re Australian.
Bernie Yu 03:28
Yep, I was born in Canberra and then raised in Brisbane, so yeah,
Jeff Malec 03:34
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 a long trip. It’s a long trip, long trip. Well, that’s why you gotta go to Christmas. You get two weeks with the kids. Yeah? So that’s that blows my mind. So optiver 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. That that’s alright,
Bernie Yu 03:58
yeah, exactly. I mean, I’d seen in previous years, people wearing these kind of red shirts. It was, 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, Optiva, part of their marketing campaign was, was handing out these red T shirts and so that’s how I got hooked. 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 get out of there. Yeah, interesting, should I say?
Jeff Malec 04:41
And what? What’s your Australian thing you do? You surf or do anything cool like that.
Bernie Yu 04:47
So I would say, swim with my brother. And I were probably one of the first, like, 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 Lanka is very popular there, like in China, it’s crickets Not, not a thing there. And then, as my parents, as immigrants, they didn’t really know about it. My dad studied in in the US, 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 being 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.
06:02
You you
Jeff Malec 06:05
piqued my interest there with JGBs like, what what did and what do the options look like on those it’s got to be a weird market being so, yeah, yeah.
Bernie Yu 06:16
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, 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, is a different style of market making.
Jeff Malec 07:19
Yeah, always at risk of the of the government or the bank, Central Bank, coming in and saying something and, boom,
Bernie Yu 07:25
yeah, yeah, I think right before then, the reason why I got a little bit interesting was with the whole Abenomics, you know, just unleashing all that stimulus, you know, I was also part of, you know, I traded a little bit with the with the Nikkei team as well. And just, you know, watching Nikkei just uptick during that period was wild as well. And just, you know, seeing those correlations between the equities and the and the and the fixed income side from a vol perspective,
Jeff Malec 07:58
yeah, you could almost argue it did you a disservice, like learning in the JGBs right of like, you weren’t seeing massive volatility inflows, there’s just slow moving,
Bernie Yu 08:07
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 so far, and I was marking 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 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 going to run. And hopefully you asked for enough of credit to take on that position, to take on that risk.
Jeff Malec 09:07
And then let’s, let’s back up a step. I’m sure people know the October name, but maybe not exactly kind of what they were doing, and how many people were were doing it. So maybe give us a little quick background on, on, yes,
Bernie Yu 09:21
is, it’s a So to be clear, so I no longer work at Optiva, yeah, yeah. But Optiva, it’s a, it’s a Dutch trading firm. They started off in the 80s in Amsterdam. Optiva is, it’s, it’s Optiva stands for like options trader. That’s 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. So. 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 US Treasury options, you’d be fine. And so it was understanding how we we made money, which was just market making, taking down the bid, ask spread, providing liquidity, providing that service to anyone, to all hedges and speculators in the options market.
Jeff Malec 10:54
And maybe not to dumb it down too much, but explain market making real quick too. So it’s right, and you’re the modern equivalent of the old floor traders in Chicago, right of right.
Bernie Yu 11:05
So market making, the best example was when we would 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, you know, farmers that need to, like, sell the products to the grocery stores, and then you have the consumers that need to buy the produce from the grocery stores. And then the grocery stores are there to create that market for people 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’d have to know when to go to the farmer, what time they were available. The farmer 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 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, yeah,
Jeff Malec 12:15
and that. But grocery stores are notoriously low margin business, right? But same with market making very low margin.
Bernie Yu 12:21
Just do, 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 100 1000 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 it’s the it’s the combination of the two which gives you the revenue.
Jeff Malec 13:15
Uh, 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 impact? So,
Bernie Yu 13:28
yeah, like, I learned a lot from Optiva, and they were really good to me. And, you know, I learned a lot. I, you know, good, good chance to give back as well. You know, we picked up a lot of interns, but at that stage, I wanted to, you know, 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, you know, what assets that I have, like, mental assets, right? Like, what edge did I have, you know, etc, etc. And then my my partner, he was like, I’ve got a family office that’s willing to seat us if you’re interested, you know, let’s, let’s, you know, think about maybe, you know, if you want to set this up. So he decided to leave in 2019 to set up all the legal work. I was, you know, thinking about it. And then basically, I had my first child in March of 2020 so the markets went wild. Um, I decided, you know, to give my leave and like, okay, you know, this would be a great paternity leave. And then I onboarded with Patronus in May of 2020 and so we kind of started everything together, our initial intentions at the time. And I think what he was, you know, 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 euro, dollar desk together, and, you know, rates went to zero. There was no more interest rate volatility. So we. Pivoted, right? We started trading just other kinds of volatility strategies, you know, we do live. 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, p5, 100 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, p5, 100 options, and we’ve been doing that ever since 2021
Jeff Malec 15:53
so explain that market making style. What do you mean by that?
Bernie Yu 15:56
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, board of strikes that’s available, seeing what has excess supply and demand. And honestly, like supporting the market makers in terms of the liquidity that’s being given to them.
Jeff Malec 16:58
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 arm? Yeah.
Bernie Yu 17:10
So when we, when we started, that was really what the 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, you know, our edge generation, where should the market be, you know, 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.
Jeff Malec 18:04
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 big firms doing this,
Bernie Yu 18:17
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 three. And then you have a plethora of, you know, smaller groups, although they are, they’re kind of being swallowed up now by the larger groups, because they have the infrastructure, because they have the access to flow
Jeff Malec 18:38
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
Bernie Yu 18:49
I would say, I this is purely speculation, because I’ve never worked at another market making firm, but talking to like floor traders, because they 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.
Jeff Malec 19:28
And the flow explain what you’re looking at in terms of flow there. So, retail, institutional, the market makers themselves,
Bernie Yu 19:36
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 flow follow a lot of ETFs that have options embedded into them. We do see that that flow coming through, especially in the pit now, because, you know, like the broker has more color. Now we can talk to. People around, you know, to say, okay, you know, what kind of institution is doing this, what kind of size, you know, how often, what conditions do they stop the flow. And I think that’s really important as well. And you know, the, you know, the classic one is like, you know, you have someone who likes to do, like the buy right strategy, just come in and sell this call. There are other, quote, unquote, more sophisticated people who try to sell a call and then buy a put spread and finance that, right? 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 five puts and that, you know, it’s just understanding the flow when they start, when they stop. And, you know, a behavioral economics comes into play. Why are they doing that? What’s their mandate, right? Etc, etc. So it’s 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 want to buy the last level, etc, etc. 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, you know, forego the, you know, the quick, instantaneous money, you know, the high turnover that requires a lot of overhead. We sit back, let the market, let the dust settle a bit, and then we kind of say, okay, where has there been too much supply, too much demand, and let’s support the market. You Oh,
Jeff Malec 21:43
taking a step back the JP Morgan hedged equity, I believe right. It’s like, yeah, 28 billion something, yeah, 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 like 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.
Bernie Yu 22:15
Yeah. Because, I mean, if you take on that, if you were the sole market maker, right? The sole liquidity provider behind that, there are a lot of Greeks, yeah, you’re buying a lot of premium, right? There’s a lot of you know, curve risk that you’re buying. There’s a lot of you know, 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 these guys that are selling it, they 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 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. You know, 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
Jeff Malec 23:47
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 over supplied here, given our models valuation, we’re going to sell into that, or we’re going to buy it. If it’s over supplied. Oversupply.
Bernie Yu 24:03
Yeah. So what we tend to do is, and we’ve learned, 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 to sell something that’s expensive, because it 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, right? So if you think you know 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 like, put selling, yes, you do have some funds that sell a. Little bit about the money, but a lot of them sell the far downside. 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 1520, 30%
Jeff Malec 25:38
and talk, talk through exactly what you mean by convexity in
Bernie Yu 25:42
that case. Yeah. So the 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 your you have that convex exposure to to make money,
Jeff Malec 26:34
and so and so. You’re not considering the acceleration of the move as cheap convicts, or you are in in a bit.
Bernie Yu 26:42
So what we try to do is, instead of getting into a U shaped payoff, we try to get into a W shape payoff, all right, right. So what that means is, you know, we have a little bit of concavity in our portfolio locally, which means 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 market, you might take on a little bit of a drawdown, because there’s no, there’s nothing. There’s no such thing is 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 a Patronus.
Jeff Malec 27:53
And globally versus locally, you’re not talking markets, you’re talking on the curve and like locally,
Bernie Yu 28:00
on the size of the move for the particular future which we’re talking about, is the s,
Jeff Malec 28:05
p5, 100, 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, right, I can argue it’s cheap for a reason, or it’s it’s inexpensive for a reason, then it gets into the difference between inexpensive.
Bernie Yu 28:29
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 adjusted perspective, it doesn’t make sense.
Jeff Malec 29:28
And how do you define risk in that in that case,
Bernie Yu 29:32
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 the 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 you’re. Capital usages. 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, it’s that down. It’s mainly the downside where we try to make sure that we’re, we’re always positive,
Jeff Malec 30:27
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. I’m long this part of the curve. And invariably, that short part loses way more in a in a spike, in an April kind of move, than they were anticipating. So, yeah, yeah,
Bernie Yu 30:48
good, yeah. We, we got into a little bit of that pension. This was that learning experience. And it’s this idea of when you’re either locally con 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 put one by five on or one by three 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 other 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, that’s where the, you know, the the black shawls formula, came from, your ability to continuously hedge, and when that ain’t. So that’s when people get into trouble.
Jeff Malec 31:57
Oh, that’s a good I see line when that ain’t. So, yeah, so
Jeff Malec 32:08
I think it was August last year. There was a bit of an event, yeah, right. So short, gamma got taken out again here April. So what? And you guys are, know, you’ll go to the sidelines, right?
Bernie Yu 32:20
So what we usually do is we will, let’s say, right up to August, we didn’t have that big a position. And the reason why was because, you know, you know we were, 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, 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 a 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 people, you know, there’s, like, Volmer, that’s, that’s another Greek that you know, can, you can use to describe that. But the idea is, you stay locally flat, concave or convexity, and then globally you you get long convexity,
Jeff Malec 33:46
yeah. So using all your Greeks, what does that look like in terms of Greeks, you’re
Bernie Yu 33:49
so, yeah, we try to stay flat, you know, Vega, Gamma, Theta, Vanna, to a certain point, like, in terms of that derivation of Vega as we move around as well. But then you can get long Volmer, 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 at the money ball.
Jeff Malec 34:18
And then that’s where,
Bernie Yu 34:20
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.
Jeff Malec 34:34
So that’s where everyone’s looking to get out, and you’ll raise your hand and back. Okay, that’s working. Exactly, yes, exactly yeah. And so totally focused on SMP right now, yes.
Bernie Yu 34:47
So we’re a four man shop right now. Our focus is, you know, 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, p5, 100 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 going to keep maxing that out.
Jeff Malec 35:32
And what are you across the board? Zero, DTEs, weeklies, monthlys,
Bernie Yu 35:38
quarterly. We primarily, 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 father dated, yeah, which for a market maker is quite far dated. But if you go to like a bank, you know 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, right?
Jeff Malec 36:45
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.
Bernie Yu 37:00
I think that it is efficiently priced at a global level. There are definitely pockets where it becomes inefficient. I think people, I think hedges, are misusing zero DT 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 you know, 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 they 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,
Speaker 1 38:12
yeah, because people weren’t pricing it, people weren’t pricing, just how much we would move. And so when people are, 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, 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 ball down in those options,
Bernie Yu 39:08
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, alphabet, 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, for example, many people can tell you, how do I replicate a portfolio that, if the future moves up one tick, I make $1 if the future moves down one tick, I make $1 from, you know, the strike. That’s just the straddle, right? But less people will be able to tell you, how do I make you know, how do I construct a portfolio? If overall level of volatility goes up by one point, I make $1 if overall volatility goes down by one point, how do I make $1 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.
Jeff Malec 40:40
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, right? Locally, yeah,
Bernie Yu 40:52
and yeah. And that’s why people turn to the futures. But the problem with the futures is the the the term structure, you just, you just get killed on the term
Jeff Malec 41:05
structure on that index. So you, I don’t know if that solves the problem. Yes,
Bernie Yu 41:10
yeah. Well, I mean, you can actually, I mean that 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 your long variance and your short vol. So variance has that quadratic effect over the vault. Again, another place to find convexity, if it’s you know, priced appropriately.
Jeff Malec 41:53
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, that’s the entrepreneurial spirit you wanted to
Bernie Yu 42:11
pick up, exactly. So it’s something that I picked up at Optiva, 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, you know, oil options, right with what’s happening over in the Middle East. Right now, it’s tempting to say, Okay, let’s stop trading s and p5 100. 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, you know, 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, 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 and 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 1000s of Millis, milliseconds behind. You know, the true high frequency
Jeff Malec 44:23
traders. But would you argue that’s your edge? And a little in a weird way, right? Yeah, they’re ignoring
Bernie Yu 44:31
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 over fit 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, yeah, our edge, if you will.
Jeff Malec 44:57
But isn’t the market makers? Is that a bit of a misnomer. They don’t have have to continuously provide liquidity either, like they have to, to make their partner’s money and whatnot, but Right? And you see that, and in April, they just pull all their bids and offers. They’re like, this is too crazy. I’m on the sideline.
Bernie Yu 45:14
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, yeah? So I think that’s invested in this infrastructure because they have, you know, a one to one traded to Dev. I know we’re one to one traded to death 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? 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, you know, for the for the army of people that they have working that’s, that’s why they need to be in the market the whole time as well. That’s why there is a nice synergy with, you know, with exchanges and market makers. Because, you know, 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, you know, whatever they need to trade.
Jeff Malec 46:27
In my opinion, there’s the retail trader is right 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’m just, I need to go in there and see a five tick wide option spread at all times.
Bernie Yu 46:56
Yeah, yeah. And, you know, I think that’s, you know, 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’s measure of liquidity is actually not just how many bonds transact, but it’s also the bid, ask spread, that deal is quote, you know, it’s all driven by liquidity. And you can talk about fundamentals, and you can, you know, like stocks are now at all time highs. There are, you could argue a lot of headwinds, but the biggest tailwind is liquidity, right? And so whatever you know, 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.
Jeff Malec 48:19
Can you take care less where it comes from Exactly, yeah, the
Bernie Yu 48:24
where that 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 you know, 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 in that. If you have another asset where it’s going to go up a lot, because there’s a lot, 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 write it, write it, write it, and then, oh, liquidity is gone. Get out, right? And so understanding, and you know, 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, like, you’re still going to get your dividend. They’re still like, you know, you think about, like, your Walmarts, you know, your Costco, you know, the consumer like the non discretionary stuff, right? 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. 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, p5, 100? No, we did it, right? Yeah, scared of the dancing, 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 I’m Yes, I’m considering skew on S, p5, 100, like an asset 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, I
Jeff Malec 51:03
do you have any worries that we’ve created a monster, so to speak, and the the whole derivatives market, the options in particular, are almost larger than the underlying right and if we keep going on this direction, right in the CME, who knows? They could launch hourly user like they they’re for profit, they’ll just keep launching new strikes and new ways to train it. So when does it become a problem? Or do you think it will ever become a problem that the derivatives overwhelm the underlying
Bernie Yu 51:32
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, okay, so that. 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 in the options or the derivative space, and there’s less liquidity in like the cash markets. Now, in terms of whether that is, you know, 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 leap like leveraged up, you can kind of take a big position in whatever’s leveraged and influence it by a minimal amount. Right? That’s not to say that only happens in the options market. You could see that happening, you know, before the 2008 financial crisis, right? Everyone was levering up on, you know, on these, these mortgage instruments and things like that. And they were just super level. In the good times, they were making a killing. But then in the bad times, yeah, it went quite a right. So in terms of the overall like 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, right? I view it, you know, coming back to my actuarial background, I do view options as insurance instruments, and your ability to buy and sell them as 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 the
Jeff Malec 53:54
And real quick, what was the Indian lawsuit? The some company that had lost money was blaming the option traders or something.
Bernie Yu 54:01
So the back story 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,
Jeff Malec 54:45
so they were moving the cash market basically,
Bernie Yu 54:47
yes, yes. That’s, that’s what they’re being accused of. Yeah. Well, what you
Jeff Malec 54:52
could argue was, like, GameStop and that kind of thing. Like, at some point, yeah, the the market makers need to hedge and they’re going to start
Bernie Yu 54:59
buying you. Yes, yeah. And that’s, and that’s what the proprietary firm is saying. They were hedging that they needed to do this, etc, etc. So it’s, it’s, I think, that came out over the the weekend. It’ll be interesting to see how everything actually unfolds.
Jeff Malec 55:16
Super interesting. Alright, so what’s next? So s, p, for now, but what would be next once, once you get that?
Bernie Yu 55:25
So Word has it that the CME will start listing single stock futures this year, and then after that, they’ll list
Jeff Malec 55:36
single stock options, single stock future options. Yeah, yes. So they already have single stock futures, but nobody trades them, right? Yeah. And then when you
Bernie Yu 55:45
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 in the tax code, yeah, 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 attacks, completely at short term capital gains. So that’s like a tax advantage to moving over to the future space.
Jeff Malec 56:31
You know, the background of that is the Chicago traders used to, if they had a loss on the air, they’d exit at the end of the year. Yeah, take the loss
Bernie Yu 56:38
if I actually, I actually don’t know the history of that. I just know it as a real Yeah, I
Jeff Malec 56:42
mean, that’s the history. If they had a gain, 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 future traders and some IRS, 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, deal is futures trades can be 6040 just trade as much as you want, and you can treat it as 6040
Bernie Yu 57:08
Yes, so we don’t hold anything over a year. So, you know that’s, that’s why it’s it’s a nice rule for us, because we try to provide liquidity for our investors as well. So they, you know, we have a 30 day redemption,
Jeff Malec 57:24
and then are you? This is all in a fund as of now, what you do SMEs, or what does all that look
Bernie Yu 57:30
like? We have one SMA and right now looks like an even split video.
Jeff Malec 57:41
We 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, what would it be? Where do you think you’d have some huge edge,
Bernie Yu 57:56
huge edge. I think it, it has,
Jeff Malec 57:59
if you wanted the front row seat. I think, I think it
Bernie Yu 58:02
would just be a front row seat. The the Black Monday. The what was it? October 19, 1987 Yeah, just being on the floor and seeing the chaos unfolds. I know that kind of seems a bit, you know, evil of me, but just to see people’s like, put skew positions just blow up. Yeah, seeing their calls increase in value on the downtick, because vol is just getting so big, that
Jeff Malec 58:33
would be brutal here, just
Bernie Yu 58:35
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? Yeah, the best and brightest minds of you know, black, black patrols 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, for the vol surface, for the vol curve, volatility, smile, smirk, you know, 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 an awesome to see.
Jeff Malec 59:30
We’ll put a link in the show notes. We wrote a blog post once. I think Brett hull, Hull 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 the uptick. And then somebody saw it and said, like, oh my god, this price, there’s a bid there. You. 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 was like, how futures saved
Speaker 1 1:00:07
the world? Yeah? Oh, that’s cool, yeah, to
Jeff Malec 1:00:11
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.
Bernie Yu 1:00:29
Following is liquidity. Like, what could cause liquidity to seize up? I follow m2 like the the money supply quite closely, our credit default swaps. Those are the 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, you know, when the Fed tightened in 2022 Yeah, that was a little bit of a liquidity event, but it was more so people taking, you know, some froth off the top right. You did see that m2 money supply down. That’s why it was probably one of the calmest sell offs in in the past three decades, or four decades, or something like it was the lowest level of that the VIX got to when the annual year on year move was over 20% downwards, yeah, it
Jeff Malec 1:01:46
was the then, which killed a lot of volt trainers, right? It was just
Bernie Yu 1:01:50
they were long their puts, and then they were long features against it, and then they the puts never went in the money, and they just got crushed on the volume and crushed on the deltas. They just get crushed all around. Yeah,
Jeff Malec 1:02:00
yeah. I think if you bought the 20% out of the money put the beginning of the year, right, and whenever in September, when we hit down 20, it was basically the same price.
Bernie Yu 1:02:10
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, 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? Right? So it’s the we had a
Jeff Malec 1:02:56
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, yeah, liquidity. That’s
Bernie Yu 1:03:10
actually a liquidity boost then for the public market, which is Yeah, 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 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, you know, be prepared. And that’s why I think the options market people trading the derivatives, they have such a, you know, a nice insight into be able to trade these alternative assets that really aren’t linked to the Delta anyway, of equities, of you know, whatever underlying that they’re trading.
Jeff Malec 1:04:03
We need, uh, liquidity futures, yeah, then we could just be like, All right, I’ve got, yeah, it’s on liquidity. I’m all good, yes, yeah. We’ll tell our friends.
Bernie Yu 1:04:13
Pitch that to the exchange. Pitch Yeah, pitch that to the CME. Uh,
Jeff Malec 1:04:17
awesome. Bernie, I think we’ll leave it there, unless you got anything else you want to throw in there? No, I think, yeah, I’m thinking, I’m good, yeah, awesome. 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, all right, we’ll see you there. See you, Jeff. Have a good one. Thanks. Bernie. Bye.
This transcript was compiled automatically via Otter.AI and as such may include typos and errors the artificial intelligence did not pick up correctly.
