how we can use it in a fundamental way toguide our trading activity. It’s almost comical how often a derivative formof an old technical analysis methodology is heralded as the new Holy Grailfor trading the markets. I’ve seen too many traders live and die as dog-matic followers of a trading system rather than using the work as a toolfor proper risk management. The best traders use technical analysis in thearray of tools at their disposal, but they justify trading decisions based onthe fundamentals of the market regardless of where support and resistancehave been identiﬁed by the charts. I’ll look at the economic data that comesfrom both Washington and private sources and discuss how these periodicreleases can impact the market on a daily basis.
Taking the mystery out of those numbers is very important to me. Ido this on a daily basis on Bloomberg TV, on CNBC, and on various otherbusiness programs. It is vital to weed out the data that might be insigniﬁcantor after-the-fact analysis in order to determine the numbers that give you,as a trader, a better feel for the future direction of inﬂation, unemployment,and consumer sentiment. Collectively, they give you a gut feeling aboutwhere the market will go and, more signiﬁcant, how you can trade andmake money from that information on a short-term basis.
Sometimes we need to remind ourselves that what we are doing is notbrain surgery or rocket science. New traders seem to get so caught up in theexcitement of the trade that they become obsessed with the markets. Theyeat, drink, sleep, and breathe trading! I regard that as the most destructivebehavior for traders because they will eventually burn themselves out andend up hating the very thing that excites them the most. We have to realizethat trading the markets is an art, not a science, and some days we’re betterartists than others. It’s an art form that is slowly being lost to computers,but, more important, it’s an art form that is very, very hard to master.
The most difﬁcult thing is shedding the yearning for instant gratiﬁca-tion. Every new trader wants to make a million dollars right away. Thatis not the way it works! It takes time, and you must realize that you haveto earn the right to be able to make money, you have to learn the pain ofthe marketplace, and most important, you have to respect the market at alltimes. When new traders started on the ﬂoor years ago, there was a rule
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of thumb that said if you can survive the ﬁrst six months, chances are thatyou’ll make it as a local on the ﬂoor. It’s one of those kernels of wisdom thatstick with you—that if you don’t fail within the ﬁrst six months, you willsucceed. It’s a very important concept to digest, especially when you are abeginning trader because trading, at ﬁrst, is completely overwhelming. Youfeel like fresh, bleeding meat in a pool full of hungry sharks; you need to beable to see the light at the end of the tunnel.
My last name is an Armenian name, Bouroudjian, which is unique in thatit has survived the ages without being lost. Other Armenian-Americans arenot as fortunate, ending up with names that were given to their orphanedgrandparents who were lucky enough to live and make it to orphanages.My parents are from the Armenian Quarter of the old city of Jerusalem,raised there by my grandparents who escaped as the only surviving mem-bers of their families during the Armenian Genocide at the hands of theTurks. Although it is an Armenian name, Bouroudjian has a Turkish origin;Bouroudj means “silkworm” in an ancient Turkish-Armenian dialect. Myancestors are from an area in Anatolia called Dikranagerd, which at onetime was a thriving trading metropolis on the old Silk Road.
Based on the Tigris River, Dikranagerd was a city lively with commercefor centuries and had an inherent entrepreneurial spirit that was unmatchedin all of Anatolia. It was a city where, for centuries, barges loaded with exoticgoods and spices from the East were ﬂoated down to Baghdad en route tothe West. In my romantic imagination I picture myself as a merchant ora silk trader, haggling with strangers from faraway lands about the pricesof everything from silk to pepper. Being of Armenian descent makes mefeel as if trading has been a part of my ethnic identity for generations, andhaving the word silk in the etymology of my surname convinces me of thatfact. Sometimes I feel as if I was born into the markets—a feeling that’shard to shed and, more notably, a sensation that has been ampliﬁed by myexperiences in the trenches over the course of the last 20-odd years.
As I take you on a tour of my world and expose some of its best-keptsecrets, I hope my deep affection for the market and its players is contagious!
Thank you!
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C H A P T E R 1
Trading Is an Art,Not a Science
I have an old friend, John Labuszewski, who worked with me at Nikko
Securities when I ran the equity futures operation on the Chicago Mer-cantile Exchange (CME) ﬂoor. Labuszewski was the president of Nikkofunds and the catalyst for Nikko entering the world of managed futures. Hewas known throughout Japan because of his past successes with Refcoin turning the four major Japanese brokerage houses into Refco’s bestcustomers. A wonderful storyteller, John would start all his speaking en-gagements with a tale based in antiquity.
He would relate how the Romans needed large supplies of wine to fuelthe increasingly decadent lifestyle of the age. To get the wine to Rome, itbecame necessary to create a network for shipping and distribution basedon contracts set for future delivery. Much of the ﬁnest wine of the daywas stored in the best possible vessels for shipping in the entire empire:huge jugs lined with lead, which both made them leak proof and sealedthem from the elements. However, the lead in the jugs slowly poisoned thewine, transforming the most expensive commodity into a slow, debilitatingdeath for those who drank it. Labuszewski would thus conclude that futurescontracts helped destroy the status quo by poisoning or driving insane theelite citizens and thinkers of the day, ultimately helping to bring down theentire Roman Empire.
I tell that story because most people who trade in the markets don’treally understand what futures are all about. Labuszewski would tell thatstory in order to create a frame of mind that would allow his listenersto change any misconceptions they might have about the subject he wasabout to discuss—the futures markets. A common perception of someone
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who trades the futures markets is that of a big risk taker—the last of thetrue entrepreneurs, embodying capitalism in its pure essence. The reality isthat the futures markets and those who trade them collectively serve oneultimate purpose: They create a liquid vehicle for risk management.
WHAT ARE FUTURES?
When the Chicago Board of Trade (CBOT) and the CME were founded overa century ago, futures markets were created to give farmers and speculatorsa central place for price discovery. On any given day on the grain ﬂoor ofthe CBOT, many of the old-time grain customers can still be seen doingbusiness, using the contracts in much the same way that they’ve been usedfor over 100 years.
However, the world of futures changed in 1971, when Leo Melamed,then chairman of the CME, together with Nobel laureate Milton Friedman,created a revolutionary concept called the International Monetary Market(IMM). They called the end product ﬁnancial futures. This advance in fu-tures no longer entailed a physical delivery of the products traded, but,rather, called for a cash settlement for the underlying contract marked atexpiration. This innovative evolution opened the door for institutions andarbitrageurs who had never seen the futures markets as a way to createa legitimate return on capital. In short, it created a new and sophisticatedcustomer base for futures, which has grown dramatically since its inception.As the use of ﬁnancial futures proliferated, the number of jobs in the in-dustry that both traded and serviced the markets exploded, starting with lo-cal clearinghouses based in Chicago and progressing to large money-centerbanks based in Europe. Prior to the establishment of the IMM, many of thesebanks had enjoyed a monopolistic interbank market in both currencies andﬁxed income, which allowed the spreads in the markets to remain wide—the spread, in this case, being the difference between the bid and the offer,or in reality, pure risk less proﬁt potential.
It became apparent to all those trading at the time that these new mar-kets in Chicago were slowly taking the edge away from their country clubnetwork and making the underlying markets much more efﬁcient. That’swhen every bank with a currency trading operation began to view the mar-kets in Chicago, not as a bastard stepchild, but as a necessary part of pricingevery transaction.
WHO USES FUTURES AND WHY?
One of the most-asked questions in this industry is: “Who really uses futuresand why?” The conventional answer is: farmers and ranchers looking for
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price discovery for their products, speculators and risk takers who have anopinion about direction, and spreaders who spread both intramarket andintermarkets. These are the obvious players, but this falls short of tellingus the crucial role each plays in creating an efﬁcient, liquid futures market.Trading is more than learning to buy low and sell high. The seasoned proknows when each group of participants is entering the market and canusually identify the impact of those orders.
This understanding of players’ actions has nothing to do with trans-parency; it’s a matter of access to the right information, which then devel-ops into a gut feeling. Every market has its own nuances, and those whospend day after day watching a given trade are able to capitalize on theadjustments made by the various market forces. For example, good cattletraders understand that hedgers come into the market at given times in theslaughter cycle and create an aberration in prices. These traders know thatif they are positioned properly, the market will inevitably open a window ofopportunity that they can turn into trading proﬁts.
OPTIONS
As we begin to study options, it becomes immediately apparent that they area world unto themselves. In fact, if we think of futures as a game of checkers,we would have to regard options as a game of three-dimensional chess.It takes a completely different type of personality to trade options thanit does to trade futures on a daily basis. One might make an argument that thepersonality of a futures trader is that of a great risk-taker and the personalityof an options trader is that of a very cerebral, risk-averse individual. That isno longer the case.
Today we are experiencing a marriage of the two worlds, as trading be-tween futures and options becomes more and more intertwined; however,regardless of the incestuous nature of the trading, the ﬁnancial world contin-ues to look upon the options trader as more quantitative by nature than thefutures trader. One reason for this generalization might be that the optionsmarkets, and the models that are used to price those markets, are basedon pure mathematics. The Black-Scholes model—the deﬁnitive model forpricing options created by Myron Scholes and Fischer Black in 1973—or aderivative of the Black-Scholes model is the mathematical formula used inevery options trading group and every institution with options exposure inits portfolio. One thing that new traders often don’t understand is that theseoption trades become so large at times, especially around expiration and atmonth’s end, that they move the market in very strange ways. Later, we’lllook at how good traders take advantage of the aberrations created by thelarge options ﬂow at certain times in the cycle.
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Who are the end users of the options markets and, more important,why are they using these contracts? This is a question that many novicetraders neglect to ask as they venture into a world that is quite foreignto them. It only makes sense to realize that anyone in the capital marketswho has exposure to a certain sector of the marketplace is looking for anaffordable way to hedge out that exposure, creating a solid risk-to-rewardratio. Individuals use options to write covered calls, enhancing the yield on astock, or they look to buy puts as an insurance policy against any downturnin their portfolios.
Of course, there are many sophisticated investors who understand thenature of the options markets and use them with greater intensity, but theyare the exception rather than the rule and the order ﬂow created by thissmall minority does not have much market impact. In the ﬁxed-incomeworld, institutions use options to create caps, ﬂoors, or collars for interestrate exposure, thus creating the type of leverage that they need and insulat-ing them from any wild ﬂuctuations in price. It is these options strategiesthat allow the creative mortgage solutions proliferating in the present-dayhousing market to be engineered.
Some of the largest trades taking place in the entire ﬁnancial worldare done at the CME in the Eurodollar options pit. As the former presi-dent of Commerz Futures, a division of Commerzbank of Germany, I sawﬁrsthand the importance of the products and the role that they played inpricing every transaction involving ﬁxed income by the banks’ traders.The situation has matured to the point that every major banking institu-tion from around the globe has found that maintaining a presence andmonitoring the action in the Chicago markets is not done out of luxurybut has become a necessity.
Institutions with equity exposure use options in many different ways.Aside from using the options markets in the traditional ways, institutions,and in particular hedge funds, use the vehicles for creating extra leverageand giving customers and investors an easier way to increase volatility intheir portfolios. Many of the new players in the options world are indexfunds that have looked to enhance their returns either by selling premiumagainst their core positions or by selling premium against a sector position.This strategy gives them more yield per million under management butincreases the risk with the investment.
OPTION PREMIUM AND VOLATILITY
Speculators love options because they can buy a call or a put and know ex-actly what their risk will be by paying a premium. It becomes an insurancepolicy of sorts and is a much easier way of protecting a portfolio or playing
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a direction in the market. Unfortunately, many speculators are not profes-sional traders and don’t understand the nuances of the options market, suchas time and volatility, which could make the right directional trade into amonetary loser.
One good example of this phenomenon is the market crash of 1987. Asa new trader, I was taught that when the market begins to break hard, itis imperative to remain calm and not get caught up in the emotion of themoment—a very difﬁcult thing to do when the world looks like it’s comingto an end. I watched as the put market began to trade at price levels thatwould have taken an Armageddon to enable to break even! Worse yet, Iwatched in terror as retail customers sent in market orders buying putoptions at any possible price without understanding the effects of spikingvolatility on options premiums. I quickly learned that trading any marketwithout understanding the fundamentals behind the pricing of that marketwas ﬁnancial suicide—maybe not an immediate death but one that couldlead to a slow, self-inﬂicted debilitating disease.
Professional options market makers, however, have a whole differentmentality and strategy associated with their approach to trading. They aretaught to make markets on every strike, and at some exchanges they areobligated to make a two-sided market regardless of their ﬁrms’ proprietarypositions. It’s been said that a good options market maker picks up thenickels and dimes in front of the bulldozer. Well, every now and again thebulldozer runs them over, but they’ve got to be sharp enough to understandhow to cover the exposure that enables them to come back tomorrow.
One of the best-kept secrets, which most professionals on the Streetdon’t even know, is that options traders buy premium, both calls and puts,when the market begins to panic. A common misconception is that everyoneis selling everything when the market has a huge move down. And whynot? Everyone knows that over 80 percent of all options contracts expireworthless. That is deﬁnitely not the case with options traders, who aretaught to be “gamma long” with the positions that they acquire. Simply put,they are trained to be long premium because volatility will spike higher,pumping up premium levels on all options strikes, regardless of direction.The best options traders in the world always have themselves hedgedout to both the downside and the upside by buying what are generallyreferred to as baby puts and baby calls that end up expiring worthless.These are options that are out of the money but are incorporated into aposition for a number of reasons, least of which is to allow the risk managerof the ﬁrm the comfort of being able to sleep at night.
Myron Scholes, one of the two creators of the Black-Scholes model,was my colleague on the board of directors at the CME for two years. ANobel laureate and brilliant thinker, Scholes was very fond of saying thatthere were many options traders over the course of the years who thanked
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him for creating the formula that allowed them to make their fortunes. Itwas an honor to have served with him on the board of directors, and theCME is still blessed to have such a distinguished person in its boardroom.Most of today’s options market makers have evolved into what the Streetrefers to as delta-neutral traders. Delta-neutral options trades are tied tofutures, which create a market-neutral strategy allowing traders or investorsthe luxury of trading pure volatility with no slippage as they enter or exitpositions. In short, traders try to capitalize on the speed of movement, orthe rate of price swings, which simultaneously provide both opportunityand protection.
Seasoned traders understand that there are only three ways you cantrade the market: direction, time, and volatility. All three of these variablesare factored into the price of every ﬁnancial transaction that takes place inthe capital markets. As simple as that might sound, it’s something that mostindividual investors and traders just don’t recognize. Trading volatility ismuch different than trading time or trading direction, and anyone lookingat the markets conceptually must understand that basic fact. Directionaltrading, the easiest concept to grasp, allows the new trader to explore theshort side of the market, usually for the ﬁrst time.
We look at directional trading every day as we decide whether to buy orsell stocks, bonds, or any listed vehicle. Trading the volatility of a given mar-ket allows investors or traders the opportunity to proﬁt on the movementof the market regardless of direction. Anyone who understands options cantrade volatility without being a professional, but the question is whetherthey’re willing to do the homework and crunch the numbers that enablethem to take advantage of the pricing of these strategies. When a traderdecides to trade time, it usually encompasses strategies that sell out of themoney premium or credit spreads in the options marketplace and monitorthose positions very carefully. A strategy based on time is usually lookingfor decay of premium levels as the contracts get closer to expiration. Thisapproach disregards direction and volatility in favor of the length of timeleft until expiration.
LIQUIDITY
Liquidity is a concept that many have studied for years, but only a fewhave acquired a realistic notion of the theory. In studying liquidity, we musttake into account the fact that there are different types of daily liquid-ity that traders will encounter. There is the liquidity of a market that wecan gauge through the open interest of a given futures contract. This isreally a barometer of the health of the contract rather than an indication
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of the size that ﬂows through the market. For example, when we ﬁrst be-gan trading the S&P Mid-Cap 400 and Russell 2000 contracts, it was im-perative for open interest levels to be at a minimum of 5,000 contractsbefore institutions could trade the product. The major end users calledthis the critical mass level needed for the institution to commit its capitalresources.
In some cases, the critical mass issue has been mandated by the charterof the institution, which, in many ways, becomes the vanguard of the capitalprotecting investors from positions put on in illiquid markets. The dailyintraday liquidity of the trade gives us an indication of how large day-tradingpositions can be without much market impact when entering or exiting thetrade. One of the best-kept secrets in the trading pits is that it becomespossible to become bigger than the market. This occurs when a day traderacquires a large intraday position and ﬁnds it difﬁcult to manage the riskfor various reasons, market impact being the greatest one.
There are times when locals move markets as if they were institutionsby virtue of the sheer size of the position they have accumulated. Every nowand again, I’m asked to explain liquidity to a visiting group of students ordignitaries in the gallery overlooking the trading ﬂoor at the CME. I usuallyask them to close their eyes and visualize a pool of water, then imaginesmall streams and large rivers feeding into and out of that pool. Some arelarge, gushing rivers (Goldman Sachs, Merrill Lynch, etc.), while others aresmall streams and tributaries. This analogy usually gives the audience I’maddressing a good idea of what liquidity is really about, or at the least,provides a starting point for their education.
If you think about it, the central price discovery mechanism, the pit,and the electronic platform collectively create that liquid pool of capital.Either way, monitoring the liquidity of a contract allows you to witness theliquid ﬂow of funds as it works its way in and out of the market and, moreimportant, how the liquidity is affected by conditions throughout the dailysessions. One of the most important things that hedge fund managers orportfolio managers do before they trade futures contracts is look at theslippage on execution of those contracts. How easy is it for them to enterand exit trades? How much slippage will occur when the trades are puton? And ﬁnally, what is the health of the exchange listing the contract? Itbecomes a function of smart money management on the part of the tradersand compliance ofﬁcers.
Usually, the tools employed include the open interest or the open po-sitions of a given futures contract. But open interest can also be deceptivebecause a contract or a market with a large number of contracts opendoesn’t necessarily give you a clear indication of the daily liquidity thatyou would need to put on a sizable position. This is most evident in futurescontracts that are used as a passive investment vehicle; an example of this is
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any of the commodity index contracts like the Goldman Sachs CommodityIndex (GSCI) or the Commodity Research Bureau (CRB). These contractshave healthy open interest numbers with low daily volume ﬁgures, but theyalso have the market makers and liquidity providers to create huge marketswhen needed.
Passive positions are put on with a strategic vision and rolled frommonth to month from quarter to quarter, thus creating a synthetic type ofexposure for investors, with huge leverage, rather than a position that theyare trying to alter and monitor daily. The GSCI is a contract I traded andbrokered during my days on the ﬂoor of the CME, but in order to put ona large position it became very important to know when the daily volumewould allow such a trade with as little market impact as possible. This wastrue not only for the contract itself but also for the underlying componentsthat make up the index. But it’s got wonderful open interest, and during therollover of that contract—the physical rolling of positions from the frontmonth to the new front month—we see quite a bit of activity, making thatperiod in the cycle the best time for customers to execute a large orderwithout leaving a big footprint in the marketplace.
Liquidity can make or break a contract. In fact, as new contracts arecreated by the exchanges, it is the one thing that they will constantly nurtureand encourage more than anything else. When the S&P contract was ﬁrstintroduced to the membership at the CME, everyone wore buttons that read“Fifteen minutes please.” This was the exchange hierarchy’s way of askingall the exchange traders to commit 15 minutes during the day to help supportthe new contract.
I remember seeing pork belly traders, cattle traders, and currencytraders all making markets in a brand-new stock index they had no businesstrading. Yet there they were, putting on positions fearlessly to help a newexchange concept succeed. Simply put, liquidity and leverage combinedare what the exchanges are marketing and selling to the ﬁnancial servicesindustry. Together, they, the liquidity providers, are the true essence of theCME and every other exchange around the world.
LEVERAGE
Many investors and traders don’t fully understand the concept of leverage;therefore, it scares everyone. More and more people tell me that they un-derstand how leverage works—they realize that futures give you the type ofleverage that no other ﬁnancial vehicle gives you—yet these are the samepeople who will go out and buy an index fund paying 100 percent marginrather than establishing a futures position, which creates synthetic exposure
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and gives the investor much more leverage and ﬂexibility. That fact provesto me that people talk about leverage but don’t really understand how touse it.
Perhaps the best example of institutional use of leverage in the mar-ketplace is found in the world of index arbitrageurs. Index arbitrage is astrategy that takes advantage of the disparity between the futures priceand the underlying cash price of a given index. Whether you’re doing anS&P arb, a Nasdaq arb, a Russell arb, or a GSCI arb, the actions and me-chanics of the trade are identical; it’s the execution of the underlying prod-ucts that differs. All index arbitrage is basically the same in structure. Theonly difference is when the arb is executed with a commodity-based in-dex rather than using equities as an underlying market. Either way, thetrader is taking advantage of the aberrations based on what you would con-sider to be a fair value between the futures contracts and the underlyingindex.
Most arbs are successful because they are able to use the 20-to-1 lever-age that futures inherently give them. Without the incredible amount ofleverage that’s available to these trading desks, they would not be able toput on the enormouse multi-billion-dollar positions that drive the marketup or down, especially during expiration and at times when the indexes arebeing rebalanced.
Leverage also gives the hedge funds the ability to enhance the yield ona given product. This is evidenced by the many index funds being marketedat present that use a synthetic futures position to replicate equity exposureand sell covered calls and credit spreads overlaying the core position. Manyof these funds give investors what they consider to be a two- or a three-betafund, which, in layman’s terms, gives investors double or triple the amountof leverage they would normally get through a conventional investment.The most critical element in dealing with leverage as a concept is managingthe risk created by the trade.
HEDGING
True hedgers are a completely different breed than the other players in thecapital markets universe. Old-time hedgers were exactly what you wouldexpect them to be: farmers, a cattle ranchers, people looking to lock in thefuture price of their underlying crop or herd. But now hedging has evolvedinto a strategy that is much more sophisticated than ever in the history ofcommodity trading. At present, the large hedges that we see moving themarket are fund managers who are looking to cover exposure in an entireportfolio without having to upset the balance of that portfolio.
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It becomes much more effective and efﬁcient for a portfolio managerwith a sizable portfolio to sell futures instead of the underlying cash po-sition in the event of expected market weakness. An example is a port-folio manager at Fidelity or Putnam who would use a short position inthe stock index contracts to hedge out any downside exposure to theportfolio without having to sell out individual issues of stock. There areswap traders and forward rate agreement (FRA) traders who hedge outevery transaction, turning ﬁxed-rate products for variable-rate products orvice versa, by using the eurodollar futures or options, which have turnedwhat was a small, niche ﬁxed-income contract into the world’s largestand most liquid.
Those swap trades—speciﬁcally, the ﬂow that comes off of the swapdesks of the major money center banks and institutions around the world—have created the largest spreaders marketplace in the world. That’s notto say that we still don’t see the old-time hedgers using futures for theirintended purpose in the agricultural markets.
Some of the old-time houses such as Cargill and Archer Daniels Mid-land (ADM) are still in the marketplace using the contracts the way they’veused them for the past 100-plus years. The questions are, at what pointdoes hedging out the risk make sense, and at what point does the cost ofthe hedge become an obstacle to proﬁtability? A strategy called dynamichedging was employed during the 1987 stock market crash, which wasa trade that sold index futures, regardless of fair value, to cover expo-sure in a breaking market. The hedging