How Does Virtu Make Money? Or Better Yet, Never Lose It?

How Does Virtu Make Money? Or Better Yet, Never Lose It?
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Virtu Financial reported higher than expected earnings on Friday, but the stock was trading sharply lower immediately following the news. On a day when stocks were broadly higher, the New York-based market maker ended down nearly 5.29%. This reversal, however, comes after a 153% run higher over the last six months, as investors such as one-time HFT critic Mark Cuban find themselves investing in a volatility hedge.

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Cuban revealed in February he had invested in Virtu, a stock that quickly climbed in value by more than 25% in the wake of the news. The stock started the year at just over $18.

This parabolic move higher came on the notion that Virtu might profit from market volatility, which some investors view as having the potential to increase. As markets become volatile firms like Virtu benefit because the bid-ask spread differential widens – essentially Virtu is allowed to charge more for its product, market liquidity, which can be at a premium during the crisis.

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When it reported earnings following a volatile market environment, Virtu pulled in $410 million in profit and beat street estimates handily. The New York-based firm earned $1.86 per share, up 1,875%, while total revenues were equally out of a statistical range, up 453% to $815 million.

But just how much of the gain was due to enhanced market volatility?

Eliminating one time items, such as the $329 million net gain from the sale of fixed income trading platform BondPoint, Virtu earned 0.76 cents a share, more than half the increase. One time savings from the integration of KCG, a market maker it had acquired earlier, could bring in $56 million in savings. After the acquisition, the combined company slashed 536 jobs from a staff of 1,200, further resulting in cost savings.

Market makers such as Virtu benefit from volatility in several ways and often employ multiple strategies.

Market making is a business that increasingly relies on intelligent computer-based systems and quick exchange access to thrive. These performance drivers are amplified by a smart non-correlated hedge strategy.

The goal of a market maker is not necessarily to hold directional market exposure, but rather to profit from providing liquidity on the bid-ask spread. What differentiates some market makers can be found in their correlation strategy. For instance, with the goal to keep an order book close to delta-neutral, some market makers can use synthetic spreads or other correlated assets. Risk exposure in the stock of CBS can be to various degrees offset by similar shares of NBC Universal that might be held in inventory. Holding stock inventory is a key to some firms success, such as Citadel as they can act as a warehouse. Market makers without direct access to an extensive inventory of stock are known to dial up and dial back exposure to one side or another of a market based on their net delta positioning. Often such market makers use synthetic products, such as single stock futures block trades, to even out their delta positioning.

That outlay of cash to purchase the hedge and the capital charge imposed for carrying the hedge is expensive so market makers at times call other market makers to see if they have inventory in the opposite position and can execute a spread transaction using a Delta1 derivative. This allows both parties to simultaneously replace the expensive stock hedge with a single stock future utilizing a trade called “The Natural,” according to OneChicago exchange President David Downey.

Several strategies and nuances of the practice exist. In the book, Flash Boys, the concept of fast High-Frequency Trading firms gaining an informational and speed advantage became one known HFT strategy. Other known approaches are for HFT traders to identify different HFT algorithms based on pattern recognition and then obtain similar directional trend exposure. Those with significant and consistent directional market exposure often did not consider “market makers” but rather speculators.

Historically a market maker depended on the size of a bid-ask spread to determine their profitability, but they also have traditionally benefited from exchange incentives.

Throughout most of modern history, those providing liquidity have always been given an incentive. Derivatives exchanges, in particular, recognizing the importance of liquidity to keep markets running smoothly, provided a financial incentive to market makers based on their volume, a commonly accepted practice among those who follow market making and HFT. The issue classic “Chicago school” market watchers have is a lack of transparency in exchange rules and order types creating an unfair advantage that is not offered to everyone.

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Mark Melin is an alternative investment practitioner whose specialty is recognizing a trading program’s strategy and mapping it to a market environment and performance driver. He provides analysis of managed futures investment performance and commentary regarding related managed futures market environment. A portfolio and industry consultant, he was an adjunct instructor in managed futures at Northwestern University / Chicago and has written or edited three books, including High Performance Managed Futures (Wiley 2010) and The Chicago Board of Trade’s Handbook of Futures and Options (McGraw-Hill 2008). Mark was director of the managed futures division at Alaron Trading until they were acquired by Peregrine Financial Group in 2009, where he was a registered associated person (National Futures Association NFA ID#: 0348336). Mark has also worked as a Commodity Trading Advisor himself, trading a short volatility options portfolio across the yield curve, and was an independent consultant to various broker dealers and futures exchanges, including OneChicago, the single stock futures exchange, and the Chicago Board of Trade. He is also Editor, Opalesque Futures Intelligence and Editor, Opalesque Futures Strategies. - Contact: Mmelin(at)

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