FUTURES
Speculators Come And Go, But What About Market Makers?
Applying Pit-Trading Techniques To Electronic Trading
by Clem Chambers
Trading futures on screen should be like trading on the floor, but it isn't. The good news, however, is that comparing and contrasting the two opens up new ways to trade.Just like every other established futures market, the London International Financial Futures Exchange (LIFFE) used to have a pit where colorfully jacketed traders stood and bellowed their orders back and forth. But in recent years, pit trading has made way for electronic trading and the old floor traders have either retired, gone to the US to work the pits there, or made the transition to screen trading.
Those who hoped to make it trading electronically have found it hard to get by; screen trading is a different game altogether. Now, most - perhaps all - have disappeared from the LIFFE market completely.
THE MARKET MAKERS
If you were to ask pit traders how they make money, it is unlikely you would get a satisfactory answer. I put this down to the fact that most are self-taught; they understand the job intuitively rather than technically - years of practice in an incredibly frenetic environment, not a textbook, has taught them their trade.
After talking to them, you can often be left with the feeling they don't know how they make money. Alternately, you will be regaled by stories of hunches or pulling off massive trades, and a never-ending flow of war stories that sound good but don't leave you with much of an idea of how their gut turns into profit.
However, market structure and a less prosaic tack yields an explanation. A pit trader is a market maker. The spread is his profit and this can be enhanced by superior information and execution.
Using the FTSE 100 LIFFE futures contract as an example, the spread has a minimum of half a point. This half-point has a monetary value of £5, and if you stood in the middle of the 50,000 contracts that pass through that exchange every day, you would be £250,000 better off. Even at £500 a day, there would be room for 500 people in the pit to make a good living without ever having to guess the direction of the market. This is how market makers make a living all over the world.
Grossly put, market theory says you can't guess market direction. If this is nearly true, it is truer for indexes than for single stocks. An index is a composite of a group of companies - in the FTSE's case, 100 - and all that random movement is rolled up into one chaotic ball. If the market isn't completely random, then it's at its most random when it comes to an index. If you buy at the bid and sell at the ask, like any pit trader can, then you will on average make £5 times the number of contracts you can turn around.
...Continued in the November issue of Technical Analysis of STOCKS & COMMODITIES
Excerpted from an article originally published in the November 2005 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2005, Technical Analysis, Inc.
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