Jacob Perlman joins Tom Sosnoff and Tony Battista as the guys discuss how traders make money. Jacob attributes this to three things: Luck, Arbitrage and Market Risk Premium. While Tom might not agree with all of these, it sparks a great discussion on how trading actually works!

The guys find out that market risk premium has historically returned 4-5% above the risk free rate. This is one reason that you are able to be profitable by trading the market. Additionally, we can compound this return by trading options with higher volatility. Since volatility is often overstated, we are able to sell options and realize additional profits when the actual moves of an underlying are smaller than expected!

Tony Battista: Thomas, we're back my friend, the skinny on option math, and Jacob in the house, welcome back my friend.
Jacob P: It's good to be here.
Tony Battista: Always nice to have you in the house.
Jacob P: Yeah.
Tom Sosnoff: How are you?
Jacob P: Ah, I'm good. I'm good. Everything is sort of level.
Tom Sosnoff: What a crazy day and then Jacob comes in all what is it, pink and orange?
Jacob P: Yeah, pink and orange.
Tom Sosnoff: I'm trying to think of what, who has pink and orange? I know the orange color … What are the colors of the University of Chicago?
Jacob P: Maroon …
Tony Battista: And yellow?
Tom Sosnoff: They have colors?
Jacob P: I think grey or something. It's like something. I don't know. Definitely maroon is one of them.
Tom Sosnoff: Definitely maroon. I bought some shirts this weekend and I looked at a pink shirt and I had to put it back down. I figured it's too …
Tony Battista: I would ride you like a …
Tom Sosnoff: I know …
Tony Battista: Because you make fun of mine all the time.
Jacob P: Wait, so what's the color of the shirt you're wearing right now?
Tony Battista: Salmon.
Tom Sosnoff: Salmon.
Jacob P: Salmon?
Tom Sosnoff: Salmon.
Jacob P: Salmon.
Tom Sosnoff: It's a … yes … we like to call this a lox color. Smoked salmon.
Jacob P: And what color is a salmon?
Tom Sosnoff: I don't know.
Jacob P: I believe that they're pink.
Tom Sosnoff: I'm not sure exactly.
Tony Battista: Don't correct him.
Jacob P: I don't think I did.
Tony Battista: I'm just kidding.
Tom Sosnoff: It looks to me like we have a fun segment today.
Jacob P: Yeah.
Tom Sosnoff: You weren't out drinking scotch when you wrote this up, were you?
Jacob P: No, coffee. Coffee always, but tea right now.
Tom Sosnoff: The three ways traders make money. Have you seen this yet?
Tony Battista: I have not.
Tom Sosnoff: You have not?
Tony Battista: Want to take a guess at one of the three?
Tom Sosnoff: It's too broad based.
Jacob P: Some of them are … They are pretty broad.
Tom Sosnoff: So let's go, ready? Three ways traders make money: Luck.
Tony Battista: Luck.
Jacob P: Like the least reliable of all the possible ways, but it's true. There are plenty of people who've made a lot of money because they're lucky, right?
Tom Sosnoff: Yes.
Jacob P: There's the old theoretical scam of you make ten recommendations differently to a thousand different potential investors and to one of them you look like a genius because you're right on all ten.
Tom Sosnoff: I have definitely made money, and so has Tony, and so has every other trader in the world, made money getting lucky.
Tony Battista: Sure, sure.
Jacob P: That's illegal. Well, no the scam. But in fact, if you have …
Tom Sosnoff: No, it's illegal to make …
Jacob P: false representations
Tom Sosnoff: False representations to all different people with the sole purpose of defrauding them, but luck is fine.
Jacob P: You're allowed to be lucky and if you just have 1024 people making suggestions, then one of them will be lucky and right all ten times, even if none of them know anything.
Tom Sosnoff: If 1024 money managers each place ten trades in a year, then one of them will win on all ten and ten of them will win on nine out of ten.
Tom Sosnoff: Those eleven will probably be able to make a career out of their one good year, hence … Are you watching David Tepper? Are you watching John Paulson?
Tony Battista: And it pays real well, too.
Tom Sosnoff: So you get a couple billion dollars. Basically, we can go through the list, because this is what it is. I've argued this all along, but that doesn't mean that any of their future trades are going to be any better than a coin toss. So it's better to be lucky than good, but being lucky cannot be relied on or planned for. Remember, if someone's been successful in the past, that doesn't give any indication of future success, unless you think there's good reason for their past success.
Jacob P: Right, if you just start placing trades randomly, 1% of people are just going to win in the top 1% by random chance.
Tom Sosnoff: There are trading groups and prop firms and individual traders that are ridiculously successful because they stick to a very set of specified and distinct strategies, and it works for them, or they could obviously have better technology. Whatever, a lot of different things. What's so good about this is, I don't think people realize, so out of a thousand … because remember, how many hedge funds are there? A hundred thousand?
Tony Battista: Too many to name.
Tom Sosnoff: Two hundred thousand? And the people go "well this person is great." Well, there's your odds right there.
Jacob P: Of course you can find someone who's great, there are so many people trying to be great, even if none of them know anything. Now this doesn't mean that you have to stay away from someone who has been good in the past because the law of large numbers doesn't mean that good luck, that's the gambler's fallacy, good luck isn't followed by bad luck. Good luck is followed by average luck. And bad luck is also followed by average luck. And all luck is followed by average luck. And so it's okay to then take their advice in the future because their advice is still going to be coin flips. But you shouldn't give it any more weight because it's been good in the past.
Tom Sosnoff: Couldn't agree more. Second is arbitrage.
Jacob P: Arbitrage is one of those things which you talk about how once upon a time back in the day it was common and you could find it regularly and now … in an efficient liquid market …
Tom Sosnoff: Now it's called high-frequency trading. There's no such term as arbitrage any more.
Jacob P: Right, there's high-frequency trading and front running.
Tony Battista: Three trillion dollars in hedge funds or something like that.
Tom Sosnoff: Three trillion yeah, but I don't know how many hedge funds that is.
Tom Sosnoff: The term arbitrage … there's no such thing as arbitrage anymore. There is opportunity in technology, more commonly known as high-frequency, but there's opportunity in technology.
Jacob P: Well and there also are … There are less efficient markets which likely do have arbitrage opportunities. Now every arbitrage opportunity …
Tom Sosnoff: Those are not for individual investors.
Jacob P: Right. Every arbitrage opportunity is going to come with the inverse of the chance to get screwed. And unless you are the fastest and the best researched and the most knowledgeable, you're going to make those mistakes.
Tom Sosnoff: Or you're willing to inventory for the longest period of time. There are very few firms who inventory illiquid stuff. And the firms that have done it have actually done quite well. But it requires big, big risk takers with lots and lots of capital.
Jacob P: It's not for people.
Tom Sosnoff: Arbitrage is simply buying something for less than it's worth and selling it for more. In the early days of trading, arbitrage opportunities may have been commonplace, but in tight liquid markets, arbitrage opportunities are rare, brief, and unreliable. Still if you ever have a definite legal opportunity for arbitrage you should take it as many times as you can before the market inevitably corrects itself. But it probably isn't worth your time to go around looking for arbitrage.
Jacob P: Right.
Tom Sosnoff: I couldn't even think of an arbitrage. So I'm going to give you a little story. I've told Tony this story. When I was a kid …
Jacob P: Oh boy.
Tom Sosnoff: … we used to do silver coin arbitrage.
Tony Battista: Silver coin arbitrage.
Tom Sosnoff: We would go from bank … I had $20. I literally had $20. We would go from bank to bank and buy two rolls of dimes, and if we could do quarters, whatever, if we had more money. But we'd basically buy as many …
Jacob P: Dimes
Tom Sosnoff: If there was like 50 banks in a couple of blocks orwhatever …
Tony Battista: 50 banks in a couple of blocks? 50 banks!
Jacob P: Downtown Manhattan
Tony Battista: Where the heck did you live? Even in downtown Manhattan. 50 banks?
Jacob P: Yeah, there's got to be 50 banks in a couple blocks in downtown Manhattan.
Tom Sosnoff: 20, easily 20 you could walk to, easily.
Tony Battista: In your town of Connecticut, where you grew up, there's 50 banks?
Tom Sosnoff: In my state of Connecticut. Yeah, actually. So anyway, or 20, whatever. And go take out the silver coins …
Tony Battista: 50 banks. Maybe 50 delicatessens.
Tom Sosnoff: Replace the money, go back and buy another one. Keep going around …
Tony Battista: You look for the silver coin.
Tom Sosnoff: Just look for the silver coins. And doing this with $20.
Tony Battista: See that's how you guys were Johnnies. You see we owned bars. We'd go to the bars. You'd find silver coins …
Tom Sosnoff: When you're 12?
Tony Battista: Yes, my dad …
Jacob P: You owned a bar at 12?
Tony Battista: Well, my dad did and he would let us go through all the change and look for all the silver coins. Those drunks, come on, forget about it, it was awesome.
Tom Sosnoff: Not all of us had a dad who owned a bar.
Tony Battista: Access to better technology, that's all it is.
Jacob P: The leavings of drunks?
Tony Battista: Hey, opportunity, arbitrage, and better technology. You just caught up a lot quicker.
Tom Sosnoff: You's was raised right.
Jacob P: And that's not even technically really arbitrage because you're putting in a bunch labor to try to extract … that's more like some sort of goofy form of mining where you've realized there's a silver vein to be had in rolls of quarters and dimes.
Tony Battista: My coin collection started my market making training account. True.
Tom Sosnoff: Were we talking to you?
Tony Battista: You can't hurt me today. You really can't hurt me over here today.
Tom Sosnoff: But I do love … Somebody first explained arbitrage to me the simplest way. Buy New York and sell Chicago. We're selling Chicago and buying New York. That was how it was explained. And you know what, that's how bad … When there was this … You may have read, years ago remember the whole concept of SOES Bandits and Raise Bandits which was, when we first got introduced to electronic trading, there was actually different markets on different exchanges, and if you had …
Jacob P: Sometimes they weren't the same.
Tony Battista: Sometimes they were not, right.
Tom Sosnoff: If you had even moderate technology, when the different … When option exchanges first became multi-exchange listed options, you could have a market on one exchange that was 50 cents different than a market on another exchange, and you could arb those if you had the right technology, whatever it was.
Jacob P: Where now you need high-frequency trading because buying New York and selling Chicago gives a very, very, very narrow window to do that. You have about, what, the eight milliseconds it takes light to get between the two.
Tom Sosnoff: Now in the future's world, everybody is owned by the same exchange, so there isn't even that opportunity. But in the option world, you can't even do that any more. So it doesn't matter. So, the only arbitrage that is out there now, if you even want to play it, is occasionally, you can sell a spread for more than the width of the strikes or you can buy a spread for under the width, whatever it is. There is an opportunity to make a couple pennies, but you have exercise risk, you have assignment risk, you have hard to borrow risk, and you have capital risk. In most cases, just for capital reasons, so let's take that out. Market risk premium, what's that?
Jacob P: So this is the actual thing. This is the actual thing that you do.
Tom Sosnoff: This is what you've been setting up for.
Jacob P: Right. This is sort of the old premise of, if you're going to take a risk, you sort of need to get paid for it. Right. So the market risk premium is just whatever returns the market produces in excess of the risk we return. So there's the risk free rate and the market generally out-performs the risk free rate over a couple metrics. Historically it's like 4-5% in excess, so …
Tom Sosnoff: Ironically, despite being defined by it's risk, profiting from market risk premium is the most reliable and safe way to make money in the market. Historically, returns from the market have consistently been 4-5% in excess of the risk-free rate. This means that we can earn well above the risk-free rate by just playing the game. But this risk is, well, a risk. What can we do to mitigate the risk without hurting our returns?
Jacob P: Right, so just being in the game, playing the market, gets you this risk premium. That's what you're doing it for. But you want to know that in on average, over the long-term, over many trials you'll be making more than twice what the risk-free rate would give you.
In practice that is risk. You don't want that. Sometimes you'll make much less, sometimes you'll lose. The key then is occurrences. Because each trade … Each thing that's risky, no matter how small or big it is. Get's essentially the same amount of risk premium. That's what matters.
If you have a bunch of uncorrelated events, central limit theorem says that you're going to shrink your standard deviation by a square root of n. You can keep your risk premium and mitigate your actual personal exposure to risk. Reduce your personal volatility or personal variance by dividing up your trades into many separate pieces.
Tom Sosnoff: People would say all the time to us how does this one firm that's trying to go public echo? How do they never have a losing day? How does citadel never have a losing day? How do these firms, whether it be timber hill or sasquahana or whatever it is. How come they make money 98% of the time?
Tony Battista: The numbers too big. The percentage is too big.
Tom Sosnoff: The numbers too big, it doesn't make any sense. They have to be doing something that's illegal … You know what? It's lots and lots of non correlated trades. It's the same reason that Tony Batista, if he was standing on the floor going back twenty years had 80% or 90% winning days. He couldn't create as many non correlated occurrences as these big firms can nowadays because they pay for order flow. They pay for the right to create the order flow. To create non correlated occurrence. It's so valuable that it's actually worth money to pay for that flow.
Jacob P: In order to beat his 90% to their 98. They needed to place 1000 times more orders, or at least 100 times more orders.
Tom Sosnoff: Of course, and that's why the individual market maker is gone. Because you can't compete anymore. Because scale wins. But it's so fascinating because everybody thinks … Oh man, they know something we don't know. No they don't. They just have more occurrences and they believe in their numbers. Which is so fascinating to me because that's all we're trying to on a truly retail level.
There's still a lot of neighsayers and doubters but there shouldn't be anybody. It's never to be for everybody. There shouldn't be doubters at this point. It's just a mathematical formula right?
Jacob P: Yeah, central limit theorem.
Tom Sosnoff: Every risky trade, no matter the size, will get the same risk premium, but the central limit theorem says that a certain number of uncorrelated trades only have … I don't know how you want to say this.
Jacob P: 1 over square root of n.
Tom Sosnoff: 1 over the square root of n. The standard deviation of a single trade n.
Jacob P: N.
Tom Sosnoff: N times as big.
That makes sense. I can't do that math part.
Tony Battista: Does it?
Tom Sosnoff: I can't do the math part. The logic is.
I'll trust him on this one.
Jacob P: When you start having uncorrelated [inaudible 00:14:20] The winners cancel out the losers. So the total amount of variation around whatever the expected value is starts to shrink down.
Tom Sosnoff: By getting those occurrences up we can collect the risk premium, since each trade is risky while staying relatively safe ourselves. What is that supposed to be …
Jacob P: [inaudible 00:14:35] since.
Tom Sosnoff: Since winners will help cancel out losers and keep our returns reliable.
Jacob P: Yeah.
Tom Sosnoff: Those are the ways you make money. Basically you're making the whole argument for more occurrences. Trade small, trade often.
Jacob P: Collect your risk premium and then try to keep your occurrences up in order to reduce your actual exposure to risk. That's sort of the trick. The risk premium's going to make you money, provided you can get that reliable, expected, typical behavior. The way that they ensure typical behavior is law of large number or central limit theorem.
Tom Sosnoff: Then just do everything smart, like high IV instead of low IV. You know what I'm saying?
Jacob P: The risk premium is not super well understood where it comes from but … At least in the black sholes model, it scales roughly with the square of the volatility. Which is why you would expect high volatility will help it and low volatility will hurt it. Because it's going to move sort of like the square of the volatilitys.
Tom Sosnoff: There's a greater chance of contraction than expansion at some point. Okay.
We should just do this all day. Can't we just do this…
Tony Battista: You want to hang with him all day and do this?
Jacob P: No, you want to put trades on. You don't want to keep talking about this.
Tom Sosnoff: We were really busy, crazy busy this morning with all of this European central bank crap and everything else. Anyways, it doesn't matter. This is more interesting to me than that. Way more. Thank you so much.
Tony Battista: Good job out of you. Thank you for coming in, we really do appreicate it.
Jacob P: Thanks.
Tony Battista: We're gonna take a quick break, about 90 seconds. We're going to come back. We have got a bootstrapper next. This is tastylive live.