This week, we're very excited to share our exclusive interview with Kevin Davitt, a special guest with tons of experience not only as a former market maker, but also as the Senior Instructor for The Options Institute at CBOE. As many long-time listeners know, we are highly selective with people we choose to bring on as guests for an interview and Kevin raises the bar, yet again, for us with an amazing discussion. During the show, we'll touch on everything from his time as a market maker, transitioning to the retail side of trading, though processes on managing positions and controlling risk, and so much more.
Kevin Davitt's Background
- Kevin is the head of The Options Institute at the CBOE.
- Prior to joining the CBOE in 2015, Kevin was a successful market maker on the floor for Letco Trading, TD Options, and Market Street Securities.
- He traded a number of Russell Indices between 2003 and 2007 and has extensive experience in commodity trading.
- He's worked with retail and institutional clientele in the markets.
- Kevin has provided commentary for Bloomberg, Reuters, Barchart, Inside Futures, and various others in financial media.
- He is a graduate of Marquette University and now lives outside of the Chicago area with his wife, kids, and their dog.
The Role of a Market Maker
- The job of a market maker is to provide liquidity to the marketplace. In that role, he learned to manage an inventory of volatility.
- The business strategy of a market maker is profoundly different than that of an individual trader. As a market maker, he was primarily concerned with the volatility risk of his inventory. Now, he is more price-sensitive directionally on his trades.
- Ultimately, as a market maker, you are managing volatility risk and not the directional/biases associated with individual trading.
Are Market Makers Evil?
- The psychology of trading can be the primary obstacle to both new and seasoned traders.
- There is a misconception that options trading is a zero-sum game.
- There is so much flexibility in ways to express a market thesis with options.
- To new options users, market makers often become the scapegoats when trades are not successful.
The Market Maker's Role in Today's Market
- The average daily volume in options during the late 90's was between 1-1.3 million per day.
- In 2018, the average daily volume was 20 million a day across 16 different venues.
- Although the makeup of the market maker community has changed, their importance cannot be overstated as market makers are beholden to provide liquidity.
- The competition that the market maker community fosters is a tremendous boon to the end-user of options as bid/ask spreads tighten and market liquidity is strong during periods of extreme volatility.
Key Takeaways for Options Trading
- Options trading is part science, part art.
- It is skewed heavily towards the science, so it is imperative that you understand how and why options work.
- Without the science of options, you don't belong in the options trading world.
- The art of options is developed over time and comes with a greater perspective and understanding of how you as an individual trader behave, how you tend to react to certain situations, and how you define your "edge.”
- Writing down the reason for any given position that you are in is absolutely crucial - use a trading journal.
- Options trading is difficult and things that are difficult require discipline. Writing down your goal and plan allows you to be exponentially more successful.
- An explicit, laid-out plan allows you to avoid making emotional trading decisions and protect and grow your capital over time.
Characteristics of Successful Options Traders
- Instead of falling in love with a certain "idea,” you have to consider the percentage of capital at risk with every position.
- Don't get locked into a specific strategy just because it was successful in the past and lose sight of proper risk management.
- The market will continue to change, so you need to adapt and be flexible as a trader rather than a one-trick pony.
- Most people do not understand the meaning of leverage when it comes to options trading.
- Leverage is great when things are working well and a nightmare when it doesn't.
- As a trader, you have to respect that leverage is powerful and has tremendous utility; determine how you are going to be disciplined in your approach to leverage.
Building a System of Discipline
- As traders, the more rule-based you are the better your odds of success.
- However, discipline does not come naturally and is often overcome by emotions.
- The more we behave systematically, the more that we are likely to live to trade another day. So, I would advocate for more and more rules-based approaches to the markets.
- Regularly reviewing your strategy is key to prevent you from making the same mistakes over and over.
Kevin's Favorite Trading Strategies
- In his experience, Kevin prefers to trade products that he has grown comfortable with over the years. Don’t chase the shiny object.
- Being comfortable with what you are trading gives you a certain edge, which is really the art side of trading.
- Kevin has moved away from trading individual names/specific stocks and into broader, index-based trading as the broader securities just seem to be more stable.
- There are unique risks (idiosyncratic risks) associated with individual stocks that do not exist in most indexes or the ETFs designed to track them. It just works better for him to try any given strategy with broad, index-based products as opposed to individual securities.
- Overall, Kevin tries to limit his directional trading strategies and express those via strategies that limit his premium outlay such as ratio spreads.
- Kevin sometimes uses XSP as an alternative to SPY because of its cash-settle and European-style expiration features.
- Being right or wrong directionally is not as important as having a positive expected outcome.
Implied Volatility Risk Premium
- Options generally price in expected volatility greater than the actual volatility. This implied volatility risk premium is subsequently realized over the duration of the option, which lends itself to positive, net long-term outcomes. (Check out OAP 138: “The Expected Probability Paradox” For Options Traders for more insights.)
- Contrary to popular belief low volatility environments have not been poor for options sellers historically.
- If you are in a position to be proactive when volatility picks up, awareness of potential strategies at your disposal is key!
Kevin's Journey as an Instructor
- From a personality standpoint, being an instructor really appeals to Kevin because no one day is the same; he can teach others about things he does not yet understand and learn continuously.
- “Once a trader, always a trader.” He does continue to trade.
- There is always something new you can do to improve your options trading skills.