or bytraders who are trading sectors that require less attention.Trading desks are normally organized by sector (e.g., government bonds,high-yield bonds, etc.). Surrounding each trader, you may find one or moretrading assistants/junior traders who help the senior trader trade his “pad” ofstocks or bonds. Some desks feature characteristic elements. For example, ifyou’re ever looking for a government bond desk, just look for the stars andstripes of the American flag.
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The TradersCHAPTER 2
Bid and Ask PricesBelow is a typical stock quote for IBM.
Bid
80.22
Ask
80.23
Last
80.22
Open
80.62
Close
80.47
Change
-0.25
High
80.70
Low
78.47
% Change
-0.31
400
B/A Size 300x2000
Volume
5830900 Last Size
This is a summary of the information traders use to transact deals for theirclients. Let’s take a closer look.The bid price is 80.22 and the ask price is 80.23. You may wonder why thereare two prices. This is because stocks, bonds and derivatives are negotiatedmarkets. Think of a flea market where the vendor is trying to sell his rip-offCoach leather bags. You ask the vendor how much, and he replies $30. Thisis his offer or “ask price.”Getting back to IBM, the bid price is always lower than the ask price. Whyis this? This is because dealers must make two-way markets in stocks.Whereas the Coach rip-off vendor is only in the business of selling fake bagsat the flea market, the specialist or trader must be prepared to both buy andsell shares of IBM. The price that the dealer (trader) is willing to buy sharesof IBM (in this case $80.22) is his bid price, which is always lower than hisask price. Confusion typically arises when a person looks at this quote andsays, “I’d like to buy IBM for $80.22 and not a penny more.” The problemwith this is that the quote you’re looking at is from the dealer’s perspective.The price that the dealer is willing to buy at ($80.22 in this example) is yourselling price (the dealer’s “bid price”) and the price that he’s willing to sell($80.23) is the price that you’re buying (the dealer’s “ask price”).The difference between the bid and ask price is called the spread. In theory,this spread is what the dealer should earn on every transaction – buying at$80.22 and selling at $80.23 all day long. If the dealer does this with 10million shares, he’ll make 10 million pennies, which adds up to a whole lotof coin ($100,000). In practice, this rarely happens, since markets fluctuatewidely, and when one person wants to sell, it’s normal for everyone to followVisit the Vault Finance Career Channel at http://finance.vault.com — withinsider firm profiles, message boards, the Vault Finance Job Board and more.
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the crowd for the exits. This is why you’ll often hear market makers andspecialists grouse about not being able to feed their children when spreadsnarrow.The “last trade” in the chart represents the last price that shares weretransacted at, and the “last size” is the size of that trade, in this case 400shares. The “B/A size” (the Bid/Ask size) indicates the size of the market.This quote indicates that the bid price is good for a trade up to 300 shares andthat the ask price is good for a trade up to 2000 shares. The cumulative dailyvolume is indicated as 5,830,900 shares. Frequently, trade sizes and dailyvolumes are reported in thousands, so a 1000 share trade appears as 1 and a100,000 share trade appears as 100.The last aspect of the quote is the daily high and low price. On this particularday, IBM traded as high as $80.70 and as low as $78.47. Customersfrequently check their executed trade price with these daily ranges to get anidea of how well they did at timing their purchase or sale. Just remember thatas a trader on Wall Street you probably won’t be the guy buying the stock at$78.47 or selling the stock at $80.70. These prices frequently reflect a dealeraccommodating a panicked seller or an exuberant buyer.
Providing LiquidityAt the core of what traders provide to clients is liquidity. Providing liquiditymeans accepting an appropriate price for a specified order quantity. This isvery different from buying and selling a stock in your personal account.Typically, as a small investor, liquidity considerations are taken for grantedsince buying or selling 100 shares doesn’t affect the price of the stock.Institutional customers like mutual funds or pension funds, however, arealways concerned about liquidity. Institutional investors own large amountsof stock or bonds, and when they want to sell, they need to sell in size. Ifyou’ve ever looked at a real-time stock quote, you’ll see that there are severalnumbers:INTC 16.10 – 16.12 10x93This is a quote for Intel. The 16.10 price is the price that dealers are willingto buy from customers. As discussed in the preceding section, this is called a“bid.” The 16.12 price is the price that dealers are willing to sell to customers14
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and is called an offer or “ask price.” The 10 and 93 represent the size of thebid and offer in hundreds – this means that the bid is good for 1,000 sharesand the offer is good for 9,300 shares. When you as a trader sell stock fromthis quote, you are “hitting the bid”; when you buy stock from this quote, youare “taking the offer.” Often you will hear traders speak of “hitting,”“whacking,” “smashing,” or “crushing” a stock. A good way to rememberwhat this means is that all of the terms that describe striking a stock bring thestock price down, because you are selling the stock. A more detailedexplanation of some of this lingo can be found in the sidebar “Trader Talk”found later in this chapter.Typically, these bid and offer quantities are market aggregates – all thedealers on the street are willing to pay 16.10 for 1000 shares, after which timethe bid is exhausted and the bid will adjust to a lower price as reflected in theorder book on the NYSE or to a lower price on the montage for a NASDAQsecurity. The mechanics of bond pricing are substantively similar.
A case studyTo examine these mechanics in detail, let’s look at a hypothetical situationwhere the mutual fund company Lucky Horseshoe Investments decides thatit wants to sell 1 million shares of Intel. Let’s say you are a trader workingwith Lucky Horseshoe. It’s your job to provide liquidity in the marketplace.This means making the right price for 1 million shares. You’ll have to makethis decision in minutes and you’ll have a salesperson ringing you every 30seconds for updates. In this example, we’ll use a lot of trading lingoexplained in detail later in this chapter.We start here:INTC 16.10 – 16.12 10x93Intel is an active stock, and the 16.10 bid is constantly in flux. Often, by thetime the salesperson takes the order and relays the order to the trader, themarket has moved:INTC 16.07 – 16.10 23x99You’re not very happy with this situation. The stock is now offered where itwas previously bid, and it appears that there’s another seller trying to make asale as well. As a trader, you’re probably on the phone with the salespersonat your firm working with Lucky Horseshoe, letting the salesperson know theVisit the Vault Finance Career Channel at http://finance.vault.com — withinsider firm profiles, message boards, the Vault Finance Job Board and more.
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price is lower. The game that’s being played here is that the salesperson istrying to get you to make a bid that doesn’t embarrass the firm, and you aretrying to protect your P&L. You’ll typically give some options for thesalesperson to discuss with Lucky Horseshoe Investments.Trader (you) : “I’ll buy 100,000 shares at 16.10 just because it was bid therewhen he came in and then we’re working the rest of the order. [We’ll discussworking orders later in the chapter.] Or else I’ll buy 250,000 shares right hereat 16.07 to work. I’d buy 500,000 shares at 16.00.”Salesperson: “Are you serious? This is Intel. We need to be size in Intel andthis is Lucky Horseshoe Investments! How about 250,000 shares at 16.10,500,000 shares at 16.07 and make a bid on the whole piece at 16.00.”Trader: “I don’t know about that. Lucky Horseshoe really killed me last time– I lost over $50,000 and they never came back. If you need a bid on thewhole piece I’ll need to talk it over with the boss, but I think you’re beingway too aggressive. If Lucky Horseshoe leaves me a working order, then I’lldo the 250,000 shares at 16.10. 50,000 more shares just came offered at adime. [Note that the salesperson and trader are beginning to discuss pricesjust in terms of cents after $16.] Make the call quickly, treat the bid subject.”INTC: 16.06 – 16.10 23x599Salesperson: “I’ll be right back.”Lucky Horseshoe Investments: “What have we done?”Salesperson: “I can do 250,000 shares at a dime if you leave a working order.The bid is down and there’s 50,000 shares offered outside of us. Trader’s stillsucking wind from last time.”Trader to salesperson: “SHARES ARE TRADING ON THE BID!!!”Salesperson to Lucky Horseshoe Investments: “Shares are trading at 6cents.”Trader to salesperson: “WHAT ARE WE DOING?”Lucky Horseshoe Investments: “Okay, I’ll sell you 250,000 shares at 9cents, working 750,000 shares and there’s more behind it.”Salesperson to Lucky Horseshoe Investments: “That’s done. We bought250,000 shares at 9 cents working 750,000 shares for now. Thanks.”
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Salesperson to trader: “250,000 shares in at 9 cents, working 750,000 sharesand the order grows.”Trader: “Great job, I appreciate that. We’re working the order. Call himback and tell him I’ll buy another 100,000 shares at 6 cents to keep up withthe volume.”These are the conversations that you’ll hear on a trading desk, and eachconversation is a negotiation that requires timely communication andteamwork.
Working ordersThe most effective way to build trust in a customer-trader relationship is toget a “working order,” which is simply an order that the trader can work overthe course of the trading day. In setting up a working order, traders put upfirm capital to get the order in the door. Once that first piece of stock ispurchased, the trader will try to recover his loss and make a profit with therest of the order. The more the working orders, the better the firm is in thelong run. Good customers leave working orders, bad customers don’t –everyone knows who the good and bad customers are and prices securities tothem accordingly.Getting the customer to leave a “working order” is the top priority of everysalesperson. Salespeople with customers who only want to sell 100,000shares when the bid is fading fast won’t have very long careers. Thesalesperson acts as the intermediary between the trader and the customer – hepasses along information, but more importantly, helps frame the decisionmaking process for the customer. The salesperson is also responsible formanaging the relationship with the trader – if a trader always loses money onhis orders, the trader’s going to make it more expensive for his customers totrade through him.In our previous example, Lucky Horseshoe Investments turned out to be agood customer. He could have jammed the trader with stock at 10 cents, butinstead offered to sell at 9 cents. In this situation, a customer without a strongworking relationship with the sell-side firm might have come back and saidthat 250,000 shares is a disgrace, and that he should have called MorganStanley instead.
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Note that at no time during the execution of the trade is the trader concernedwith whether or not INTC is a good investment. A lot of people have themisperception that trading on Wall Street is about looking into a crystal balland trying to divine the future of an investment. It’s not – the trader’s role isto provide liquidity and to determine an appropriate price given the interestsof the customer and the firm. The trader knows the stock is going down andthat there are other sellers in the marketplace, but his job is to accommodatethe customer, take a hit on the first piece of business and hopefully work theorder to the firm’s advantage. The best way to think of trading is that thetrader maintains an inventory and that he’s trying to constantly unload thisinventory into the marketplace. Ideally, at the end of the day he’s completelyflat (i.e., has worked out of all the positions) and has some profit to show forhis efforts.If you’re a more cerebral type and enjoy performing extensive analysis beforemaking an investment decision, then there are less flow-oriented productsthat you can consider, like fixed income derivatives and credit default swaps.These desks tend to do a lot of modeling before pulling the trigger on anygiven trade, but the role is still very clearly defined by the customer (“clientdriven” rather than “proprietary”). If you enjoy working in a high intensitywork environment, enjoy negotiating and have an ability to think quickly onyour feet, then trading is definitely for you. If you prefer to makeinvestments, then you should perhaps consider the investment managementindustry. (See the Vault Career Guide to Investment Management to learnmore.)
Q&A with a Junior Trader at a BulgeBracket Firm in New YorkQ: What is your morning routine?My day begins at 6:30 a.m. I get in before my trader gets in to go overyesterday’s trades to make sure that everything that was doneyesterday matches with the trade details that are generated by our backoffice. The next thing I do is go over news headlines for each of ourstocks. When my trader gets in around 7, I must have all of our startingpositions confirmed, and somewhat more interesting, I discuss anynews in our stocks to get an early idea of what my trader is thinking andto plot strategy for the day. This exercise is particularly importantduring earnings season, and although we try and stay as flat as possible
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overnight, the reality is that this is a customer-driven business, and wefrequently carry substantial positions.Although the market opens at 9:30 a.m., it is always trading on Instinetand other electronic crossing networks. We relay any noteworthytrades or indications to our salesforce, and also review yesterday’sAUTEX trade volumes.AUTEX is a self-reported trade volumeadvertisement that each broker-dealer updates throughout the day.We have an internal research system that carries all the written notesthat our firm’s research analysts have written overnight. Of course Istart with the notes that mention the stocks in my sector, but I’m a realmarket enthusiast and I try and read everything. It’s great to be tradingan industry-focused group of stocks, but it’s also important to staycurrent with the bigger stock market picture. One of the majorresponsibilities I have had has been to build relationships with our firm’sresearch analysts and to communicate timely market information fromthem to my trader, and also to the salesforce.A fixture of our morning routine is the morning meeting, which isdifferent from the morning research call. The morning meeting is anopportunity for the entire sales and trading department to get togetherand exchange information about large trading situations and anyrelevant news that may have been released overnight relating to thedesk’s positions. It’s also a chance for us to grind the axe, so to speak.We try and anticipate what will happen throughout the trading day,especially if we had a large situation that we or our competitors areworking on. We’re also working closely with the sales desk todetermine what is the best way to get customers to trade with us, andhow to make sure that this incremental business is profitable.Economic statistics are normally released at 8:30 a.m. I maintain aneconomic calendar since these numbers are frequently market-movingstatistics. The market tends to focus on several economic figures at agiven point in time. For example, when the economy is strong,everyone is worried about inflation, so the CPI and PPI are very closelywatched. In recent years, with the economy has been weak, we’vebeen very focused on initial jobless claims and the monthly employmentreport. The bond market normally reacts first, then the S&P futuresreact and often there are big head fakes, especially if there are largerevisions in previously reported statistics.Following the economic reports and some breakfast (which I fetch fromthe firm’s cafeteria), my trader and I work on our indications.Indications are basically advertisements that we post to the buy-side to
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solicit interest in our stocks. These indications (buy or sell) are basedon our prior day’s customer activity, and our proprietary view on thestock. Our proprietary view is based on a combination of fundamentaland technical factors. In theory, the way – indications are supposed towork is that we go out as a large buyer of say, Intel. A buy-sidecustomer who wants to sell Intel notices our buy indication, and thetrade volumes that we’ve been advertising. It’s very possible that hethen gives us a call and we negotiate a bid for some portion of the stockthat we think he has for sale, and this generates an order that we areable to work throughout the day. Of course, most of the time theseindications don’t go nearly as well as expected. (Quotes are essentiallyadvertising, and a trader might find that when it comes to actuallyhitting a bid or taking an offer, the other side may not honor the price,or may not want to leave a working order.)The next thing we do is adjust our markets to reflect our openingindications. Other dealers are jostling in the box for position. Buyers(or dealers who want to project the image that they are buyers) arejoining the bid or moving the bid up. Sellers move to the offering side,and if they have an interest in lowering the opening price (or projectingthe appearance that they are sellers) will lower the offer. It’s OK formarkets to be locked (bid price equals offer price) or crossed markets(offer price is lower than the bid price), before the opening, but by 9:30a.m., markets need to be unlocked and uncrossed.Q: What happens when the market opens?The first five minutes of trading are pretty crazy. The buzz that hasbeen building in the trading room since 9:00 a.m. explodes with theopening bell, and the trader focuses on the larger situations, and prettymuch leaves the rest of his pad on autopilot. My job is to make surethat we’re not giving away the shop on these smaller situations. I’veearned substantial trading responsibility, and my trader doesn’t feel theneed to micromanage every single situation. I take orders, work theorders and in the process, I am building up my relationship with thesalesforce here in New York and in the regional offices. Traders needto command the respect of the salesforce, and it’s been really importantfor me to make prices and to work with the salesforce to meet theneeds of the clients. The more trades I do, the more respect I’m ableto earn from my trader, from the salesforce and ultimately from ourcustomer base.Q: How do you learn the business?I’m also always keeping involved in the situation that my trader isworking on, and keeping abreast of the larger situations on the desk. I
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can actually scan each trader’s profit and loss on the screen, sogenerally looking at who’s making or losing the most money is a goodplace to start. Learning in this business is pretty much all experiential,so the more I learn from others in terms of what works well in whatsituation with which individuals makes me a better trader. I need to payspecial attention to the cast of characters involved – what works wellfor one customer doesn’t always work well for another customer, andit’s important to keep learning from my own mistakes as well as themistakes of others.But make no mistake about it, a trading desk is all about business, andyou can really do yourself a big disservice by asking stupid questions atthe wrong time. Keep a notebook, write down your questions and atthe end of the day after the market is closed, try and work thesequestions into your conversation with the trader. There’s a smart wayto ask questions and a stupid way to ask questions, so be smart aboutlearning. Having said that, there’s a grace period for every new hire, sothe time to ask stupid questions (i.e., “How do I read this quote?”) is atthe beginning of your tenure.Q: What makes a good trader?Well, we’ve already touched on a couple things. It’s important to beable to assess a situation and to make good prices given what’s goingon in the market and also the particular customer that’s involved in thetransactions. This comes with experience. Good traders don’t crackunder pressure but are able to think clearly and make the right decision,regardless of how much money they’re making or losing. A good traderbalances his need to make money with the interests of the customer.Q: What do you enjoy most about the business?It’s a fast-paced environment and there’s always something going on. Ienjoy the challenge of thinking fast on my feet, pricing securities andmaking markets. Every day we start with nothing except our wits andenthusiasm, and it’s our job to consistently make a profit. The tradingenvironment is the closest thing to a true meritocracy that you’ll everfind on Wall Street, and it’s good to know that if I do a good job andmake money for the firm, I’ll be compensated accordingly.Q: What’s the worst part about your job?We always eat lunch at our desk, and it’s my responsibility to place theorder and to pick up the food. Enterprising trading analysts always keepa stash of menus – you can never have enough lunch options, andtraders appreciate variety. Sometimes I think that I didn’t sign up to bean overpaid lunch delivery boy, but it’s all part of the process and
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everyone has to pay their dues. Sales-traders also eat their lunch at thedesk, but they’re a little less harried and can afford to take a little moretime with the menus, since there’s normally a lull in trading activity.Traders, however, can’t afford to take their eyes off the screen, sinceeven over the lunch time lull, prices are fluctuating.Q: What happens to the trading analyst that just can’t make it?Trading is a meritocracy and you are only given responsibilitycommensurate with your ability to get the job done. Unsuccessfulanalysts generally are not given the same opportunities to trade assuccessful analysts, and typically at the end of the two-year program,if they haven’t been able to provide a value proposition to the desk, thenthey’re not hired on a full-time basis.
InventoryIn a retail business, inventory refers to the quantity of a product (shoes, pantssoccer balls, etc.) on-hand and available for sale. Inventory in the tradingbusiness refers to positions of stock that the trader has accumulatedthroughout the trading day. The ideal situation is that the trader matchesbuyer and seller and collects a spread by buying low and selling high. Forexample, if he buys 100,000 shares of POS at $20 and can immediately sellthe shares to another buyer at $20.06, he has made a riskless profit of $60,000for the firm. The problem is that matching buying and seller is only an idealsituation – it is in fact is one of the hardest things to do. Buyers always havecompany, and sellers are never alone either. So, the trader is forced to earnhis keep. He does this by adding to or selling from his inventory. Themarkets fluctuate, so the risk for the trader is that he buys a lot of stock whenthe markets are up, and for some unexpected reason later in the day, themarkets go into a freefall. The trader is now losing his shirt because theinventory he purchased in the morning is getting crushed.Traders are not investors. If the trader is long 100,000 shares (has 100,000shares in his inventory) down 50 cents a share, he’s already down $50,000and needs to make some really tough risk management decisions. The traderdoes not have the luxury to say, “Well, I think the stock is fundamentally agreat story, and while it may be down today, I have confidence that in six
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months, the stock will recover.” This is all hogwash from a trader’sperspective, who feasts and starves on the daily tick chart.Should the trader sell the stock for a loss? If so, then what are the chancesthat he can later sell an even greater slug of stock to the customer that sold tohim in the first place? This may not sound like a very attractive option, butaggressive traders have a knack for snatching victory from the jaws of defeat.One strategy is to get out there and keep buying the stock in anticipation thatthe seller has more stock for sale, and will be anxious to continue makingsales to keep up with volume. This is called “taking the stock down to a levelwhere it will trade.” A trader would follow this strategy if he senses that alarge investor, say, Fidelity, is trying to change its position in a stock andeither buy up a bunch of it or unload it without being overly concerned withsmall price changes. In the case discussed where the trader has 100,000shares and is down 50 cents a share, he would be betting that Fidelity willcontinue to sell the stock, even if the price drops, so he’s buying up shares tosell back to the firm.When the trader takes the stock down another $1, he’s now losing $150,000on his inventory. He may have sold some stock down the way, but normallyif you hit the Street with enough shares (offer to buy many shares), otherdealers get out of the way pretty quickly, and the price tumbles with very fewprints (trades). At this point, the trader gets on the phone and tells thesalesperson to call the buy-side trader (Fidelity, in our example). Thesalesperson puts on a panicky tone and says something like, “Joe, this stockjust got creamed. I don’t know who hit it, but it wasn’t us and it’s for saleeverywhere. You want to make some sales here?” Joe is going to be pissedthat the stock tumbled without getting any notice from the salesperson. Thesalesperson will say that the stock crumbled with no shares printing (trading),probably because there’s another seller out there. Several factors willdetermine how much stock (if any) the buy-side trader will sell. These factorsinclude: the portfolio manager’s (also called the “PM,” this is the person atthe buy-side firm responsible for managing the money) instructions (does hehave an ultimate low or is this a get-me-out-at-any-price type order), therelationship between the buy-side trader and the salesperson, and perhapsmost importantly, the VWAP.Buy-side traders continually track something called the volume-weightedaverage price, or the VWAP. The VWAP is essentially a running averageshare price of the stock throughout the day. Buy-side-traders (traders whoVisit the Vault Finance Career Channel at http://finance.vault.com — withinsider firm profiles, message boards, the Vault Finance Job Board and more.
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work for investment management firms) who are buying want to be as farbelow the VWAP as possible, and sell-side traders (who work for investmentbanks) try to be above the VWAP. In the context of our example, if the buyside trader can sell shares at these low prices without totally wrecking hispersonal VWAP (i.e., making his average selling price lower than theprevailing VWAP), then he will do it. He’s also more likely to make the saletoward the end of the trading day. At the beginning of the day, sellers can bereluctant because the VWAP can change more rapidly when there’s lessvolume on the tape and more time for the stock to trade. If the buy-side tradersells enough stock at these low prices, the salesperson happily buys the stockand banks the sales credit. The buy-side trader can report a good VWAP tohis portfolio manager and the trader has the comfort of knowing that hecrushed the stock and that as long as no one else tries to do the same thing,the shares should recover and he can at least break even on the trade.This is just one example of how traders need to manage their inventory. Inreality, trading is a game with infinite possibilities. What if the trader poundsthe stock, buys another 100,000 shares and then some malevolent dealerdecides to whack the stock (sell the stock and drive the price even lower) toinflict pain on a competitor? What if pounding the stock gets another sellerin the door, and now the trader has to accommodate multiple sellers whilehe’s lugging a huge position? What if the seller doesn’t want to sell any stockdown at these prices? Then all the trader has done is caused himself a nicebig loss. The adept trader is one who learns from