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Thought Leadership

A Hedge Fund Manager’s Thoughts on Trading Options on Robinhood

As we reach the end of 2020 we all have a chance to reflect on this year’s main events. Most will point to the pandemic, its subsequent lockdowns, the political instability, the election etc.

In Finance, though, perhaps one of the most significant events has been the rise of Robinhood and the influx of young, inexperienced, speculative new traders into the market.

A lot has been written about this phenomenon (by CNBC, SeekingAlpha, Bloomberg, and NY Times, just to name a few). In fact, there are some funds and firms out there researching this further in order to come up with possible trading strategies to take advantage of it. But aside from pushing up beaten down stocks and contributing to, some would say, the forming of financial bubbles in some names, nowhere has their impact been as noticeable as in the options market. One of the hedge funds I co-founded uses options strategies as one of our main tools and we have noticed an impressive increase in option trading volume in 2020. The reality is that we had been observing a pattern of increased option interest for a few years, but this year’s surge has been impressive.

 

In fact, as Goldman Sachs reported in July of this year, single stock options trading volumes were bigger than the actual underlying stock shares volume for the first time ever in history.

Graph of Single Stock Options Trading Volumes Bigger Than Share Volumes

While shocking, it comes as no surprise that cash-strapped, risk-hungry, young new traders are attracted to options, as the leverage they offer is exceptional, and one can make very large returns if their prediction comes to pass. Buying call options on almost any name in March this year would have been immensely profitable, and a lot of new traders jumped on this bandwagon. While this was happening most professional funds, ours included, were designing hedging strategies to survive or profit from further potential downside moves, which never actually happened.

This means that possibly, for a few weeks this year, random Robinhood option traders significantly outperformed the ‘smart money’ crowd.

 

This is a double-edged sword.

While it is certainly exciting to experience high returns on your first ever trades, it conditions a lot of these new traders into believing that the strategies they put on are more valuable than they really are.

As a result, it is not surprising that this year’s put-to-call ratio has dipped to one of its lowest readings ever, suggesting that most option players are using options for bullish speculation (by buying calls) rather than for risk hedging or bearish speculation (buying puts).

That this is happening in 2020, a year when the worldwide economy has been crushed by the pandemic, is ironic to say the least. 

Graph of Equity Put/Call Ratio by CBOE

In the long term, this is unlikely to be sustainable.

Buying calls in markets with inflated valuations might work for a while but, as history tells us, the situation will revert back to its mean at some point. This is not to say that the markets will turn bearish, it’s just a comment on the mechanics of the option market. If a constant bull market, fuelled by inflation and the dollar’s devaluation, is the new normal, then option premiums will also increase, making call buying more expensive and lowering the odds of success of call buyers

The reality is that, in the long run, most retail option buyers will end up losing money. 

The only reason buying options has such an attractive risk/return proposition on paper is because the odds of success when buying options are low. Otherwise nobody would be willing to sell these instruments.

However, this influx of mostly call buyers presents a lot of opportunities for hedge funds and other professional players. Short option strategies that seek to sell options with inflated premiums to speculative unsophisticated traders are showing significant returns. This is because options trading is much more complex than it seems. Aside from the price of the underlying stock (delta) you need to at least take into account the option’s time (theta) value and its volatility (vega) values. Very few of the Robinhood traders are doing anything like that, which means there is significant value to be captured by exploiting this anomaly.

So if you have been trading options on Robinhood, I would suggest you keep track of what is and what isn’t working for you, and try to educate yourself about the complex world of options before you risk a lot of your capital.

If admitted to the TrendUp Now program, during the L2 course we will take a deep dive into the option strategies that we use day in and day out at our fund, and that we have been successfully running for years now. They may not be as initially enticing as buying cheap calls and striking it rich, but they are much more regular and consistent.

At the end of the day, the intelligent investor who is able to generate superior risk-adjusted returns on a consistent basis will always beat the speculator who had perhaps gambled and been lucky a few times. The latter, at the end of the road, through a string of bad trades, will likely lose most of what he once gained.

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Thought Leadership

Why don’t hedge funds have websites?

In the 21st Century, it is a given that if you do not have an internet presence (website, LinkedIn, etc), you simply don’t exist. Nowadays, even corner lemonade stands run by grade school kids seem to have a website or at least a presence on social media.

However, there is one notable exception: Hedge funds.

Most hedge funds do not have a strong internet presence if any at all. When they do, even top multi-billion hedge funds like Renaissance Technologies, with over $110 B in Assets Under Management, have very simple websites that look like they were built in 1995.

Their LinkedIn page is even worse. It has no logo and no content and their description is literally this: “——————————“.

LinkedIn page of the hedge fund
LinkedIn page of the hedge fund “Renaissance Technologies” that has neither a logo nor content

Furthermore, many hedge funds employ savvy firms to do the opposite they do with most clients: keep their name away from the spotlight. Many hedge funds ask their employees to not publicly state online where they work.

So what’s going on? Why does your corner mom and pop shop have a stronger internet presence than a multi-billion dollar company? Why do so many hedge funds act as if they were secret intelligence operations?

There are six main reasons:

1. Legal: Up until 2013, it was actually illegal in the United States for hedge funds to have any sort of effective website as they were barred from advertising and engaging in “general solicitation”. This was a rule designed to protect smaller investors from investing in expensive, complex and not very transparent instruments like hedge funds. Even if that rule has now been somewhat relaxed, the industry has gotten used to not having a strong online presence, and many funds are unlikely to change as that could welcome potential unwanted legal scrutiny.

2. Clients: In order to be legally allowed to invest in a hedge fund you must be an accredited investor (currently defined by rule 501 of Regulation D as having an income of over $200k and a net worth of +$1M) to even be considered, and most hedge funds have much higher wealth requirements, as well as very high minimum initial investment amounts. Many hedge funds understand that an online presence is unlikely to influence these sorts of clients to make such important investment decisions. Rather, hedge funds use their network to personally reach out to potential qualified investors.

3. Exclusivity: Just like the secret hipster bars and restaurants hidden behind nondescript doors in industrial buildings are all the rage, in the 21st century, it seems like not being online confers an aura of secrecy and exclusivity. It’s almost like a reverse psychology exercise: “We don’t need your money so we don’t advertise”. This can be very powerful to lure high net worth individuals. For example, Bernie Madoff’s Ponzi scheme grew exponentially because, in part, his fund’s extremely low profile and secrecy made it seem like a highly coveted and prized opportunity among the world’s wealthiest).

4. Need: Unless you’re a new fund or your capital rising through traditional routes is not working, there is actually very little need to have any sort of public presence. Your fund may be fully subscribed or you may not be looking for more capital. And if you do, chances are your own network’s word-of-mouth may be enough to get the few extra investors you need. It might simply make no sense to spend money on developing an internet presence, and then dealing with the resulting unsolicited attention or requests from unqualified wannabe investors.

5. Regulation: Hedge funds are loosely-regulated private partnerships and are not required to report their performance to any centralized database. Funds will usually only publicize their performance to prospective investors and marketing databases if they are looking to attract new investors. While there are some private hedge fund databases that try to gather performance data, the reality is that they are very incomplete as they rely on voluntary reporting. Furthermore, if the fund owns less than $100MM in regulatory assets, they do not even need to file any SEC forms, making the fund virtually non-existent not only in the eyes of the public, but also for regulators and government agencies. This is exacerbated when the fund is not even registered in the US (many opt for jurisdictions with even laxer regulations like Bermuda, the Cayman Islands, Hong Kong, Luxembourg, Singapore etc).

6. Privacy: One of the aspects that HNW individuals value the most is privacy. If the fund they’re investing in were to, for example, publish their performance or detailed investment philosophy online, some clients could be concerned that certain parties (government, journalists, competitors, etc) could use that information against them. The same goes for hedge fund workers. The preferential tax treatment for carried interest is also politically controversial, adding to the desire to avoid the spotlight. 

So, all in all, if you look for a hedge fund on Google or LinkedIn and expect to find a lot of information, you will probably be disappointed. Anyone can build beautiful websites nowadays. Maybe those who choose not to is because they can afford to do so.

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Thought Leadership

Been trading for a while, ever thought of doing it professionally?

We are often approached by people who ask us if it’s possible to transition from being an independent trader/investor to working at a hedge fund or a proprietary trading firm.

The reality is that technology has allowed retail traders access to information, financial data, and trade execution that were once only available to a select few professional firms. This has contributed to the creation of an ever-growing number of people who have developed valuable trading and investing skills independently, and who could also put them to use professionally in a buy-side firm.

So…what should you do if you’ve been trading for a while and are now thinking of doing this professionally?

The benefits are well-known: Buy-side finance has some of the highest compensation levels of any profession in the world, and the jobs tend to be challenging and intellectually stimulating. However, cracking into the industry is no easy feat. (To learn more about buy-side vs sell-side, check out these articles by Mergers & Acquisitions and Investopedia.)

Everybody is unique and has different backgrounds and education/career trajectories, so, rather than an overall analysis of who hedge funds are looking for, we would like to focus on how you can use your trading experience to stand out.

Know your Style

Being a jack of all trades is not something that is generally viewed favorably in the industry. Hedge funds tend to be highly specialized. They may have a specific strategic approach (long/short, global macro, etc), a theme (tech, value, etc), a preferred analytical approach (fundamental, algorithmic, etc)… As a result, it will be much easier for you if you specialize in a specific trading or investing style before interviewing for a job. This refers not only to the products you generally trade (equities, options, futures, etc), but also the approaches you take. You should be able to discuss your strategic approach with the person interviewing you, and be able to give some concrete examples of how this was applied in real life.

Hedge funds work hard to avoid what’s called “style drift”, that is when they keep on changing strategies. Consequently, you should probably also avoid personal style drift and stick to one or two approaches that work for you. I’d rather hire someone who has, for example, been trading grain futures with a very specific approach for three years, than someone who has bought and shorted all the futures contracts available, hundreds of different options, and half the stocks on the S&P, without any rhyme or reason. That is not to say that having knowledge about different markets, products and strategies is a negative thing (on the contrary!), but if you’re talking about your personal trading strategies it’s best not to be all over the board.

Have a Track Record

In the age of Robinhood anyone can call themselves an investor or a trader. Buying a few stocks and currencies and a couple of call options do not make you one. You need to be consistent to stand out and your past performance can help you do this. You should be able to show a good track record (of at least around 18 months).

It doesn’t have to be perfect, nor should it have necessarily beaten the market. But you need to be able to explain why you did what you did, what worked, and what didn’t.

Good traders will try to keep track of what they do, so having something like a trading journal can be a great complement to the performance statistics that you can download from your brokerage platform. Hedge funds understand that daily profits of, say, 20%, are exciting but impossible to maintain, so they’ll be looking at the overall returns of your trading, for example over one year period. Returns of around 10% annually can be fine, especially if you can show how, while you were producing these returns, you had hedged your positions against possible market crashes, which would have allowed you to profit from a down market as well. Now, obviously, if your track record shows a loss of 76% then you’re better off not showing anything, and it may be better to take some time to gain some more knowledge before returning to the markets.

Lastly, your track record should have evidence of independent thought: If all your profitable trades have been purely due to successful trend-following momentum stocks (chasing up a stock like Tesla), it is unlikely they will see much of value other than a lucky streak.

Get Professional Mentorship

While the first two steps are important, the reality is that hedge funds and other buy-side firms receive thousands of applications and it is highly unlikely that they will want to hire a self-directed trader just on a good strategy and a track record. As we discussed in our previous article on hedge funds, they’ll be looking at your educational background, professional experience, and skills. If you have access to someone who works at a hedge fund, you should try to get under his wing and learn as much as possible.

But, if you’re like most people, that is not something that is easily attainable. Programs like TrendUp Now not only help you develop the necessary skills for these positions, but also connect you with professionals in the field that will provide you with personalized advice and possibly connect you with relevant opportunities.

Have Past Relevant Experience

If you do a quick job search for reputable hedge funds and other buy-side firms, you’ll see that most jobs require some previous relevant experience.

This is the classic catch-22 where if you can’t get a job you can’t get experience which makes it hard to get a job.

For some opportunities, you can overcome this by showing professional experience in any finance-related field, even if you were not in a trading or analyst role.

But the reality is that nothing beats a good internship at a fund.

TrendUp Now provides internship opportunities to its qualified students so by the time you apply for jobs in the field you have the relevant experience you need to quickly stand out from the rest.

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Thought Leadership

Hedge Funds Part I: What Are They And Who Are They Looking For?

Ambitious people with an interest in pursuing a career in Finance often have different options available to them. After some research, one of the first questions they tend to ask themselves is,

“Should I work in the buy-side or the sell-side?”

In short, the sell-side is about developing and selling products (stocks, bonds, entire companies if you’re in M&A) to investors, making money from fees and sale commissions; whereas the buy-side involves making investment decisions to generate returns from your or your clients’ money. The sell-side tends to be dominated by investment banking, while the buy-side is dominated by hedge funds and private equity.

We’ve observed that, in recent years, going into investment banking has become the goal of many.

This comes a bit as a surprise as, in general, individuals with an entrepreneurial mindset are probably best suited for a career in hedge funds. In general, if you’re successful, the compensation in hedge funds is clearly superior to that of investment banking, and the hours tend to be more predictable. The work also tends to be more intellectually stimulating as there is less of a mechanical, hierarchical approach to tasks compared to those in investment banking. This is not to say some people can’t also thrive in the sell-side, but we’re just surprised that nowadays university students tend to gravitate towards the -generally less appealing- investment banking path as the ‘default’ Finance path. There is no denying that landing an IB job out of college will open doors also in the buy-side later on (in fact many HF recruiters look for IB analysts with 1-3 years in). But it seems like most just stay in the sell-side. This is a relatively new phenomenon which actually creates big opportunities for those who want to explore the hedge fund path.

This phenomenon is due to the fact that the big investment banks have taken university recruitment seriously and it is not rare for them to come to college campuses and offer well-structured internships and summer programs. Interestingly enough, before Dodd-Frank’s Volcker Rule was passed as a result of the 2008 Financial Crisis, large banks also had proprietary discretionary trading departments, but, due to that regulation, this space has moved to buy-side firms because of the lighter regulation.  Essentially that means that it is now harder for students or recent graduates to access trading roles without having some sort of connection. At TrendUp, we bridge this gap and train and help interested candidates break into the harder to access, but exciting, high-paying careers of the hedge fund industry.

The history of hedge-funds is one of the investors seeking independence from institutional rules and government regulations: Hedge funds allowed investors a carte blanche to go after the best opportunities.

Today, it is a +$3T industry with more than 10,000 firms, of varying sizes.

Graph of 'Value of assets managed by hedge funds worldwide' by Statista
Graph of ‘Value of assets managed by hedge funds worldwide’ by Statista

One of the most exciting aspects of the hedge fund industry is its huge diversity. For example, the funds will have different investment horizons: Some may put trades with a 10yr horizon, others, especially in the algorithmic space, maybe just for the next 10 seconds. Hedge funds also have a wide array of strategies: Long/short equity, market neutral, merger arbitrage, convertible arbitrage, event-driven, credit, distressed credit, fixed-income arbitrage, systematic, global macro, short only, etc. This means that it is not hard to find a hedge fund that matches a candidate’s specific personality or skill. However, if a candidate is unaware of what their skills and personality are and how that fits in the industry, they will have a hard time finding the right match. 

This is why at TrendUp Finance we have data analysts and fund psychologists working with us to assess our candidates’ skills and personalities so we can then match them with the most compatible positions in the sector.

The space is extremely competitive, so it’s important to be prepared when entering a hedge fund. The reason is that hedge fund operators look to deliver absolute -not relative- performance, in any type of market.

Hedge funds want to ‘beat the market’, not just ‘match it’, like other players in the financial industry.

As a result, it tends to attract ambitious people who want to advance fast. The result is a faster environment (major decisions can be made in hours) more creativity, more risk, and therefore huge money potential. It’s not like an asset management firm where keeping up with the market average is enough. In those firms, a new trader may have time to hone and develop his skills, but in the hedge fund industry it is quite more cutthroat and entrepreneurial, so having beforehand knowledge is a big advantage in order to avoid making costly mistakes and losing your seat.

This is why TrendUp Finance trains its participants in hedge fund strategy and equity and derivative analysis so, by the time they apply for a position, the employer has the certainty that the candidate already has the necessary knowledge and skills to successfully contribute to their firm. Hiring the wrong person for a hedge fund position is extremely costly for the company and traumatic for the employee, so having TrendUp train, filter, and match their candidates with compatible positions is a win for all. 

In general, successful candidates tend to have some of the following: 

Personality Skills

Candidates in this industry tend to show reliability (you need to be able to show you can be trusted), strong work ethic (during intense times you need to be able to produce results efficiently), stress management (you need to be able to maintain a cold head if the market turns against you), effective communication (you need to be able to communicate your trading ideas to senior management or the market situation to the fund’s clients), and creativity (you need to come up with money-making ideas with attractive risk/reward scenarios, sometimes thinking outside the box).

Education:

Long gone are the days where people without a college degree were able to enter the industry. Having a college degree is now seen as an essential requirement for most buy-side positions. In particular, hedge funds tend to look for

  • Evidence of having successfully overcome the competition (for example, your class rank -top 20% for example-, even if it’s from a second-tier school).
  • Evidence of strong ability/work ethic (your GPA, your school)
  • Coursework in Finance, Economics, Math, Statistics, or Computer Programming

Mentors:

Finding someone in the industry to mentor you is an extraordinary asset. Building those connections will allow you to not only learn directly from that person but also tap into their network. Getting a mentor is easier said than done, especially in such a competitive industry. Showing commitment, patience, humility, and hunger for learning can go a long way. By participating in the TrendUp programs you will be exposed to top professionals in the field, often in 1-on-1 settings, which can be a great way to start exploring a mentoring relationship.

Stand Out:

There are many candidates applying to a limited number of internships and jobs in this industry. Standing out is therefore critical. Extra elements that make you different from your peers (published research, trading experience, background, etc) can go a long way. At TrendUp we work with our candidates to help them publish investment research and manage a portfolio.

All in all, if you feel you have some of these skills, and a career in Finance appeals to you, the buy-side in general and hedge funds specifically, offer you an exciting, challenging and highly rewarding opportunity, both personally and financially.