How Do Smart Traders Make Money?

Faulty Prices

Here’s how hedge funds and investment banks always seem to buy and sell options at the shockingly best prices: ‘Type W’ models. When you buy/sell options, you are usually making the trade based on whatever price you see on screen, or with the help of an indicator. But unbeknownst to many, options prices are forecasted and settled long before your trade is even an idea. It may sound incredulous, but allow me to explain.

Hedge funds like Point72 and Citadel all agree to post-market settlement prices. These are blocks of options trades that get transacted at the exact moment the market closes. Ever wonder why there’s so much volume exactly at the close of the bell? Well, that’s why. The funds do this because they are primarily using options to hedge, rather than speculate, so deciding on a fixed value ahead of time is a great way to minimize volatility.

Here’s an example of the kind of sophisticated software these funds use (retail trader version):

How They Make Fortunes From It

As pictured, they rotate their pricing models based on different market trends. You may have even heard of one, likely the Black-Scholes model. In high inflation periods like now, banks and funds use Implied Volatility and Merton-73 models to calculate the ‘true’ options values.

This type of modeling is also how fund managers develop these seemingly crazy trade ideas. A few major ones that you’d find in use today are relative value trades and volatility arbitrage. For relative value trades, since they have an idea of what the price should be based on their models, they can look for overpriced options and sell them to collect the spread when it goes back down to true value. Volatility arbitrage works the same way, but instead, they capture the spread of True Volatility — Implied Volatility. As you can see, these models exist for everything from futures, to stocks, to bonds.

With Options-Quant, you have access to the Jump-Diffusion model and hundreds like it. Our team of traders, statisticians, and economists, we offer direct and practical guidance on branching into systematic strategies with our platform. Whether you want to trade a form of arbitrage, exploit an inefficiency, or even just want to learn and test new strategies, we are here to provide 1-on-1 support.