Market Overview

Former Market Maker Keith Harwood On Combining Technical Trading, Leveraged Derivatives

Share:
Former Market Maker Keith Harwood On Combining Technical Trading, Leveraged Derivatives

Options market maker and professional trader Keith Harwood spoke with Benzinga about generating alpha through mispriced options.

The Beginnings

Harwood is a University of Notre Dame economics and theoretical mathematics major who pursued professional trading after graduation. 

"My senior year of college I interviewed for a number of jobs, one of which was an options market making firm called Group One Trading," he told Benzinga. 

Market making entails the provision of liquidity in financial markets.

“If somebody from Goldman Sachs wants to sell a bunch of options, and you’re sitting there as a buyer, you’re hoping somebody from Bank of America Merrill Lynch or Citadel [Securities], will come in and buy options to alleviate your excess inventory.”

Harwood began trading in 2005. 

“It took about a year of really intense training. We spent three to six months just working on the theory of options.”

Harwood traded equity and ETF options on the CBOE, PHLX, PCX and ISE exchanges.

Trading The Great Recession

Trading became difficult six to nine months after the suprime crisis, Harwood said: spreads declined alongside volatility and the market adopted a short bias.

Cognizant of this shift in market environment, Harwood said he moved to a firm that would allow him a greater edge with the ability to trade option nuances. These include expectations of volatility shifts or skews, the relative value between calls, puts and at-the-money options.

Harwood joined the Cutler Group, trading as a self-backed market maker, before becoming an Eurex and metals portfolio manager at Nico Holdings LLC. 

“I initially traded Eurex fixed income options — the equivalent of the two, five and 10-year in Germany. After a couple months of sleeping for an hour or two a day, I realized that was not going to work.”

During this time, Harwood completed his MBA at the University of Chicago Booth School of Business and joined a commodity-focused hedge fund.

Harwood said he came to a realization: “Helping these people exploit the retail trader was not of interest to me anymore.”

Strategy Evolution: Leveraging Bias To Profit From Mispricing

Prior to the Great Recession, Harwood developed a long-option bias. This, in conjunction with technical trading, allowed him to take advantage of the current market, which prefers options selling, he said. 

The Black-Scholes model used in options pricing exhibits a log normal distribution, a consequence of the fact that prices cannot go below zero. This distribution presently exhibits a fat tail to the downside, Harwood said.

“That’s kind of how selling options works; you’re going to make money, but when you lose, you will lose more than you make.” 

The thought in Harwood's mind was how to create a scenario that takes the skewed distribution and applies technicals so he could say the stock is more likely to go up than down, he said. 

The market is built for crashes, Harwood said. 

"The market says the stock is going to go up, a little bit, but not a lot."

Harwood took this thesis and inverted it: his contrarian strategy exploits opportunities where the stock may gap higher or grind lower.

Risk Mitigation

“Risk management should always take precedence over expected returns,” Harwood said.

Traders must set their risk tolerance, he said.

“Once you set your risk — say $500 — you look at the trade and ask yourself, what is the best way to risk $500? Is it with an outright equity position or an options position, or whatever else?”

Harwood manages his portfolio’s risk, hedging against systemic issues.

“We trade the Nasdaq components. If something bad happens, say a U.S.-China tweet goes wrong, or bad Apple earnings destroy the Nasdaq, that could be a bad day for my portfolio. So, I hedge using Nasdaq options.”

Harwood told Benzinga that he can look at his portfolio and create a synthetic position that mitigates his overall risk in the market.

“When stocks rise, you can do a little more stock picking. When we have a crashing market, it’s really efficient to use an index or index ETF as a hedging mechanism.”

Harwood compared market crashes to the cliche of throwing the baby out with the bathwater. 

"In a falling market, they sell everything." 

Going Forward

Harwood’s career goal is to educate the retail trader.

“I’ve gone through a lot of interesting market environments, including the subprime crisis, the grind higher afterwards, quantitative easing and everything we’ve had going on over the last year or two.”

Harwood likened options to a tool.

“I can walk into my living room with a power drill and destroy everything. Or, I could use that power drill and a number of other tools to completely remodel my kitchen and make it look beautiful.”

Derivatives can provide unique leverage or wreak havoc if not used correctly, he said. As a result, Harwood aims to protect traders with his education and research service.

"There’s a reluctance to say, ‘why would I invest in other people educating me?’ However, if you’re not investing in your own personal education, you’re basically treating it like a game," he said. 

“Thinking of it as a career changes your mindset.”  

You can get in touch with Harwood at optionhotline.com, where he's the chief option strategist.  

Keith Harwood was at the Traders4ACause conference Oct. 11-13 in Las Vegas.

Related Links:

Warrior Trading Spearheads Education, Mentoring With Real-Time Trading Simulator

Real Estate Fintech Beekin Nominated For Benzinga Global Fintech Award

Posted-In: Broad U.S. Equity ETFs Technicals Options Exclusives Markets Trading Ideas Interview ETFs Best of Benzinga

 

Related Articles (BAC + GS)

View Comments and Join the Discussion!
Lightning Fast
Market News Service
$199 Free 14 Day Trial
Book A Demo
Learn How You Can Succeed In The Market With Benzinga Pro

Fastest Market News

Real-Time News Alerts

Customizable News Filters

Book A Demo

USDA Offers Interim Regulations, Public Comment Period For Industrial Hemp

Ask Our Experts 10/30/19: The Size Of The Australian Market