Trader networks and options risk management

• Author: Peter Locke,Li Sun,Naomi Boyd
• Date: 01 July 2020
• Published date: 01 July 2020
• DOI: http://doi.org/10.1002/fut.22117

J Futures Markets. 2020;40:1031–1048. wileyonlinelibrary.com/journal/fut © 2020 Wiley Periodicals, Inc.

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1031

Received: 24 October 2016

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Accepted: 20 March 2020

DOI: 10.1002/fut.22117

RESEARCH ARTICLE

Trader networks and options risk management

Naomi Boyd

1

|Peter Locke

2,†

|Li Sun

3

1

Department of Finance, West Virginia

University, Morgantown, West Virginia

2

Texas Christian University, Fort Worth,

Texas

3

Department of Finance, Shanghai

Business School, Shanghai, China

Correspondence

Naomi Boyd, Department of Finance,

West Virginia University, Morgantown,

WV 26506.

Email: Naomi.Boyd@mail.wvu.edu

†

In Memoriam June, 2016.

Abstract

We examine the effect of trading partner concentration and a matrix of

variables which dictate the relative importance of a trader to the network on

a set of large member proprietary traders’risk. An increased closeness

centrality and concentration of trading among network partners are found

to reduce price, volatility and rebalancing risk. We further explore the

nature of trading concentration established through traders’recurring

trading relationships to find that trading with an established and small

network has a positive, yet costly, effect on inventory management.

Relationships among market makers are important to managing their

portfolio of risk.

KEYWORDS

networks, options, risk management

1|INTRODUCTION

Market makers provide liquidity and price discovery. The provision of liquidity requires short term

inventory holdings, which exposes the market maker to inventory holding risk. In options markets, inventory

risk can be characterized as a portfolio which includes price, volatility, and rebalancing risk to

examine the compound impact of each of these types of risks on the overall position. While futures option

market makers may use the underlying futures market to manage their delta risk, this appears to be

incomplete (Boyd, 2015). Another risk reducing measure is to execute proprietary trades with other

traders through interdealer trading, for example as examined for futures markets in Locke and Sarajoti (2004)

(Figure 1).

In this paper, we study how an interdealer network can facilitate efficient and effective risk management

practices of market makers in the New York Mercantile Exchange (NYMEX) natural gas options markets.

AsshowninBloch,Genicot,andRay(

2008), network links are shown to play two distinct roles: first, they

actasconduitsfortransfer (provide insurance); and second, they act a s conduits for information (facilitate

monitoring). Both of these outcomes are particularly important for market makers in financial markets as

they seek avenues to unwind unwanted inventory holdings, especially at the end of the trading day or

during periods of increased volatility. Stanton, Walden, and Wallace (2018) provides evidence that network

parameters can help to better predict liquidity and information measures than traditional market microstructure

variables. Therefore, we seek to utilize network parameters to better understand the risk management practices

oftradersinthisarticle.

While most of the trading in financial markets has moved to electronic platforms, physical trading does still

occur. For instance, while all futures market trading has moved to GLOBEX, a viable and active open outcry

trading pit still remains for many futures options markets.

1

Other markets also maintain personal interactions for

trading, which becomes especially valuable when there is informational asymmetry. For example, although an-

ecdotal, a recent trip to the floor of the NYSE during an IPO revealed that the interconnectedness of specialists on

the trading floor dictates price discovery and transactions functions. Brokers physically discover the appropriate

price for all IPOs and relationships among traders provide important information to one another that cannot be

garnered from electronic transactions.

This study provides unique insight into the importance of face‐to‐face interactions for certain types of asset

classes, even as electronic trading becomes the predominant mechanism for facilitating trade in financial markets.

It also helps to explain why we see such high levels of OTC participation in markets whose trading pits have closed,

as proprietary traders seek out mechanisms to reduce their risk and improve their profitability through network

connections(Babus&Kondor,2018;Neklyudov;2019). In short, we choose to focus on trader risk management

because it dictates market frictions such as transactions costs, which ultimately have a direct impact on the

efficiency of pricing and liquidity in financial markets. We study whether relationships matter to the management

of traders’risk portfolio by employing network theoretical principles to empirically test the validity and importance

of these relationships in creating a well‐functioning market.

Reiss and Werner (1998) find that traders on the London Stock Exchange often choose to use interdealer trading

to unwind “extreme”inventories. Though futures options traders are not obligated to provide liquidity and

maintain price continuity (Boyd, 2015), inventory risk still exists and the trading with a small group of core traders

may help manage this risk, especially when there is large liquidity shock or price shock in the market. As studied in

Ambrus, Mobius, and Szeidl (2014), the effectiveness of a risk sharing network can depend on the size of the shock.

Asthesizeoftheshockincreases,asmallercircleoffriends offers better risk sharing compared with a large group

of loosely connected friends.

FIGURE 1 Universe of option market makers of entire network. The network of all 140 active market makers in the natural gas option

market. Node size is proportional to the number of links it has. Red nodes are 20 large traders. Yellow nodes are large traders’top five

partners. Many large traders’top five partners are also large traders [Color figure can be viewed at wileyonlinelibrary.com]

1

Here we focus on traders in futures options markets to better understand how they utilize relationships to manage their market exposure to risk.

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