|* Virtu does not trade on informational edge|
* It mitigates risk through diversification and law of large numbers
* Retail traders don’t have the capital to mimic this strategy
Virtu does not trade on informational edge
Doug Cifu sounds like a guy you’d like to have a beer with. Although as the CEO of one of the biggest market makers in the world he is a billionaire a few times over he comes off as like a regular guy from Jerz who is just as happy to talk about hot dogs as he is to explain the intricacies of variation margin.In a fascinating Odd Lots podcast with Tracy Alloway and Joe Wiesenthal he takes the audience on a wild stream of consciousness ride that explains the most arcane details of the fractured modern electronic market structure and Virtu’s attempt to provide intermediation in every major marketplace in the world.
It mitigates risk through diversification and law of large numbers
But the most interesting throwaway line in the whole interview is that Mr. Cifu candidly admits that Virtu not only does not have an informational edge but that despite its seemingly full proof way of making money it sometimes gets run over losing tens of millions of dollars during the day.
Market making is basically a mean reversion strategy. You are acquiring inventory lower and selling it higher or selling inventory short higher in hopes of buying it back lower a few seconds later. Almost all retail traders (when you look at their actual trading records) eventually fall into trying to mimic this approach. Although retail traders pay homage to the idea of trend they invariably fall into the trap of trading mean reversion. We are so culturally ingrained to buy cheap and sell low in all other facets of our lives that we naturally think this method will work in trading. It does not.
|Retail traders don’t have the capital to mimic this strategy|
The reason market making is so hard as a trading strategy is that it’s success depends on a two way market. In order to buy low and sell high you need both supply and demand. Most of the time that is exactly what happens and retail traders often get lulled into thinking that this is easy money as you bank profits over and over again. But sometimes supply or demand completely disappears. Mr. Cifu talks about Virtu’s inability to deal with one way flow in GameStop stock this past January when it first verticalized over a period of a few days and then promptly tumbled. He admitted that the firm suffered eight figure losses as it first had to continue filling offers on the way up and then absorb bids on the way down.
The difference however, between a goliath like Virtu and the average retail trader is not just the billions of capital at Virtu’s disposal, but the fact that the firm was enormously diversified across markets and assets. While market making was failing in GameStop it was succeeding in thousands of other stocks, forex pairs and futures that Virtu was trading at the same time. This is perhaps the single biggest error that most retail traders make – lack of diversification when trying to trade this strategy. Market making will always fail when it comes to a single instrument because eventually every instrument will have a vertical move that will wipe out all your efforts to fade it.In retail forex there is no better example of this than the Great Britain Pound which I am certain has blown up more retail accounts than any single currency pair in history. Retail traders compound the market making problem by often martingaling into their positions. Martingaling of course is the idea of adding to your inventory as the price moves against you. This simply speeds up your chance of blowing up. This single fastest way to lose all your money in forex is to martingale into a pair that is essentially a one way trade. Even if you are ultimately correct in your assessment the margin call will always liquidate your position before it has a chance to recover.
Will retail traders stop trying to make markets like the big boys? Probably not. Our cultural impulses are just too deeply ingrained, but don’t be surprised when it doesn’t work out. One of the biggest players in the game has warned you.
Read more articles like this on my new website