Scalping Gamma - The Stock Market Shakeup

Updated: Dec 3, 2019

Evolution is real. Nietzsche was right in that the upgraded version of itself is better than the previous, despite Plato's perspective on the original impact on the world. The financial markets have evolved past the point of recognition from its initial inception. Stock orders were traded in physical paper shares, and if you did not have possession of those shares, you did not own them. I can only imagine how they tracked open orders and stocks outstanding in the early days of structured financial markets.

There have been many pivotal changes to the stock market over time, and I will not bore you with the complete history here. If interested, check out our website, we go into great detail. The most significant change to the modern-day stock market came in 2011 when trading on the stock room floor was digitized. Orders were no longer executed by guys in colorful vests shouting or hand signaling their bid/ask across the room. The day after they flipped the switch must have been somber to hear silence instead of the constant cheering and hollering all day.

It was digitizing the trading floor that allowed for higher volumes of trades exponentially faster. Anytime there is an exponential change to a process, the productivity and efficiency chart on a new scale. If a process took ten steps to complete before, and now only takes three today, that is potentially a 300% increase in productivity and efficiency. There are going to be companies that capitalize on this opportunity by investing in the new process immediately. There will be skeptics of the industry that send out research teams to report back and eventually roll out the new method. There will also be those who reject the new and say, "we will do it like we always have."

Let us take a look at some examples of each category as the new digital stock market was rolled out. The investment firms that jumped out and saw arbitrage in High-Frequency Trading made the most money. They were deploying market shifting techniques that prevented traditional traders from getting the bid/ask price they requested. Bewildered by the fickleness of the market and inconsistency of trade pricing, one trader from RBS, Brad Katsuyama, followed the fox back to its den. To learn more about high-frequency trading, check out Flash Boys: A Wall Street Revolt. Brad discovered that traders who were closer positioned in proximity to the internet hub of New York were getting better pricing on their trades. What high-frequency traders found is that there is arbitrage in computer latency. I guess having that old Dell is not going to cut it anymore. Electricity and the internet are physical properties that take time to travel from one location to another. Therefore, a trader in New York will get better pricing and be able to make more money than a trader in California executing the same positions.

You can imagine the frustration of traders watching their margins shrink before their eyes. RBS did its homework first, although it was quicker than others to position their trade desk in the heart of New York in efforts to best the High-Frequency Traders at their own game. Equities now trade in nanoseconds, and once quantum computing hits Wall St, gamma will create a new class of derivatives. The concept of "Scalping Gamma" comes from leveraging Artificial Intelligence to discover the sentiment of the market and identify the most likely direction of an individual stock. Gamma can be viewed as the best leading indicator of the delta change in a stock price. If you know where the market will be based on media sentiment, then it is much easier to position in-the-money trades. High-Frequency Traders combine market sentiment analysis with automated trading bots to create what is called a "Black Box."

The idea of a Black Box is to generate absolute compounding returns using technology to analyze and execute trade orders. The stock trading industry went from all hands on deck to find the best stock to buy to a hands-off approach that generates absolute compounding returns. Traders take the technology a lot more severe as the paradigm shift of calling someone on the phone to place trades has been replaced with computers that automate trade executions.

It allows for cheaper and faster trades to occur for individual armchair investors and traders. Digitizing the stock market provided greater efficiency for market makers and the ability for consumers to trade in "real-time". Real-time to an individual investor is a few minutes, day, week, or year. Real-time to a high-frequency trader is nanoseconds. From the time you push click to enter an order on your computer at home or mobile device to the time the electric signal gets to New York, the pricing of your position was already traded at least 20 times. We should not have to pay $10 for an $8 stock, but we do on almost every individual trade.

Wall St realized the unfairness of these actions, although they did not stop doing them. Instead, they created Exchange Traded Funds (ETFs) using the technology. ETFs are a great way to mitigate risk while participating in trends in micro-sectors. How will the market continue to evolve in an ever-increasing rate of technological advancement? To learn more about high-frequency trading check out Flash Boys: A Wall Street Revolt.

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