Analyzing Abounding Asymmetries

By Chris McKhann

The Internet and online trading companies have put a tremendous amount of knowledge in the hands of retail traders, in some respects equalizing the playing field. But the fact that you may have as much information as the pros doesn't mean you should try to beat them at their own game.

Professional traders, market makers, broker-dealers, and institutional money managers theoretically don't have any more information than you or I do. Hedge funds aren't supposed to, but I suppose it depends on whom they have been talking to. Online brokerages like tradeMONSTER provide analytics that rival anything that the pros have. Information websites provide all the data you need, and then some. (Jon and Pete have long been at the forefront of bringing institutional data to the retail trader.)

It used to be that the "investment experts" had a real hand up, an informational asymmetry that essentially allowed them to pull money from the pockets of retail traders and investors. That informational asymmetry is largely gone, but recent developments show that there are other forces at work.

First of all, there is the very real possibility that many pros are using inside information, or at least data that isn't publicly available. Then there is the issue of speed, as many funds spend huge amounts of money making sure they can trade a lot faster than the rest of us. They put their servers right next to the exchanges and program supercomputers to trade for them. The high-frequency traders may provide liquidity, but there is definitely a speed differential.

Finally, there is the asymmetry of trades. Most funds (and traders, for that matter) like positive carry trades, the type that pay us on a daily basis. In the option world this involves net selling strategies--covered calls, short puts, iron condors, and the like. Hedge funds have a lot of other ways of playing this using currencies and even selling CMOs (collateralized mortgage obligations).

The flip side of this is the negative carry trade. Buying insurance is a negative carry trade, and buying puts--or VIX calls--costs money on a daily basis through time decay. The asymmetry comes from the payoff: Negative carry trades can lose only a small amount, while they can pay multiples of that loss.

Positive carry trades are the exact opposite. You can make only a small amount and can lose a lot if things go awry.

Institutions use positive carry trades because they have to keep up with the Joneses. Funds that don't keep up with competitors are left in the dust; they don't get the inflows, and investors want their money back. So they can't "afford" to lose money on insurance and other negative carry trades. The only time they are willing to bet on asymmetrical plays is when they are a sure thing (like maybe when they have more information then the rest of us).

Where does this leave us? You are unlikely to beat the pros at their own game. They have more money, resources, and brain power at their disposal, not to mention those "expert networks."

However, you don't have the pressure of keeping up with other funds and reporting your returns, so you can take advantage of asymmetrical payoffs more easily than institutions. If you're willing to pay the insurance premiums, you can have asymmetrical payouts in your favor when the markets make a big move, which they do far more often than most people think.

When funds do make asymmetrical bets, they usually turn to options. And because they generally do that when they have an advantage of one sort or another, we can ride their coattails by following the option market and identifying unusual activity--allowing us to make asymmetrical bets without the insider trading.

Disclosure: None