holders. I cohosted Squawk Box with MarkHaines the morning of the Microsoft dividend payment and told the worldthat we would witness a rally at the end of the session because of the needfor the index funds to reinvest the dividend that was being paid out. Sureenough, the day ended with a late surge that led the S&P up more than10 full points as Microsoft ended unchanged minus the $3 paid. There aresmall additions and deletions to the indexes a few times a year, and Vinnyand Denny taught me that the shrewd trader can capitalize on the situation.It’s the corporate events such as the Microsoft dividend, or any stockthat goes ex-dividend, that launches the equity funds and those holding
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index arb positions into action. This is especially prevalent when a mergeror a buyout is announced that affects the underlying components of thepositions they carry, creating what is commonly referred to as trackingerror. The trader will identify a company in play and ﬁnd another companythat is in a related industry and spread the two against each other. This is acrude example of what is called risk arbitrage.
Many of the risk arb desks on Wall Street follow the mergers and ac-quisitions (M&A) activity with a microscope, hoping to ﬁnd the next dia-mond in the rough. Vinny and Denny taught me to play off the risk arbsin the market. Using options, Vince had been the original options traderfor Merrill Lynch when the concept was introduced to the ﬁnancial com-munity. Vinny and Denny showed me the leverage and how to identifythe trends taking hold of the market. Searching for the next opportunityturned many of us into addicted tape watchers. It became almost secondnature to stare at the headlines that raced across the walls of the exchange,hoping to catch an informational edge and create an opportunity for ahigh-percentage trade.
STATISTICAL ARBITRAGE
Another form of arbitrage activity that has become very popular in the lastdecade is statistical arbitrage. Stat arb, as it’s called, is based on the scienceof statistics and is used in different methods by the hundreds of globalinstitutions that employ the strategy. There are different types of stat arb,but the most proﬁcient traders using this technique were those at CooperNeff (CN). CN originated as an options trading company based out of thePhiladelphia area and had made a reputation for being a good currencyoptions trading house. In fact, prior to its acquisition by Bank NationalParis (BNP), the ﬁrm had been an important part of an Asian institutionthat had used CN’s systems and knowledge to hedge out the bank’s inherentglobal risk.
A simple form of stat arb consists of ﬁnding two stocks, completely un-related sectorwise, but which track one another dollar for dollar. Stat arbshave been found that spread auto stocks against cosmetics companies, forexample, or technology against cement. This market-neutral strategy in-volves being both long and short the market at the same time, but ﬁndingstatistical anomalies that yield the desirable high- percentage trade. A morecomplex derivative of stat arb is the strategy that most new traders ignore,even though it makes up 10 to 20 percent of the daily volume on any givenday. Statistical index arb, which became an art form at Cooper Neff, incorpo-rates the math behind basic stat arb and morphs it into a form of index arb.
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The best trader using this strategy that I’ve ever come across is ScottWeisblum, a brilliant young Wharton grad who was hired by CN. I ﬁrstmet Weisblum when I was chairman of the CME’s equity index committeeand we decided to launch the S&P MidCap 400 and the Russell 2000 futurescontracts. Knowing that the new contracts were in desperate need of instantliquidity, I contacted the index arbitrage community, starting with Vinny andDenny to muster the critical mass necessary to ensure the success of thenew contracts. I was told by many that index arbitrage with the new indexeswould be difﬁcult because of the number of stocks and the illiquid conditionof most of the composition.
When I came across the group at CN, I quickly realized that theywere doing something completely different from what I had seen fromany other institutional arb traders. Weisblum came on as both the mid-cap and Russell markets began to heat up and found an audience withthe global fund managers. It was very important to get both contractsto the point that the passive funds, those that used a futures position asa synthetic equity holding, to participate in the daily session. Weisblumand CN found a statistical anomaly that they were able to capture atvarious times during the course of the session. It was a combination ofcutting-edge technology and creative mathematical thinking that led Weis-blum and the traders at CN to incredible levels of success for themselvesand for BNP.
During the late 1990s, the geographical nature of the pit environmentmade it critical that my operation be able to handle all the different marketsin which the arb was being done. I found myself in the highest-priced realestate on the exchange ﬂoor, right between the S&P 500 futures and thesmaller, newer indexes that had just been started. From the time the con-tracts were created until late 1999, Weisblum was the largest user of both theRussell and midcap futures contracts, taking what were little niche marketsand transforming them into the dynamic trade we see today.
Much of the success we are witnessing in the Russell and midcap futuresare a direct result of the liquidity provided in the early days by Weisblum anda few others. Aside from being a crucial part of the liquidity, CN always founditself on the cutting edge of technology, constantly asking the exchange topush the envelope when it came to tech. As a member of CME’s boardof directors, I was in a constant dialogue with the group at CN about anumber of subjects, including the use of certain types of connectivity thathad previously been banned. Some of the biggest arguments I found myselfin concerned bringing technology into the pit, which many ﬂoor traderssaw as an infringement on their franchise. I can still see the faces of pittraders yelling at me, insisting that my actions, and those of my fellowboard members, were detrimental to the market!
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In hindsight, nothing could have been further from the truth, and I’mproud of the decisions we made during those critical early days. It wasonly through the efforts of customers such as CN and Vinny and Dennythat the board of directors acquired the credibility to drag the exchangemembership, kicking and screaming, into the twenty-ﬁrst century.
EARNINGS
When looking for factors that drive volatility during a session, earningsseason has no match. During the four times a year when corporate earningsare announced to the waiting ﬁnancial world, the opportunity for traders toﬁnd proﬁtable trades can be numerous. Not only does the earnings release ofa company directly affect the price movement of the stock, but many tradersfail to realize that most of these large-cap stocks are also an important partof the composition of the various indexes. As small as it may seem, a movein one or two large-cap stocks can be enough to skew the entire index oneway or another. There will be sessions when most of the broader indexes arelower, yet we look at the Dow Jones 30 and ﬁnd it positive on the day. Thisaberration is usually the result of a single stock, after an announcement,changing the entire complexion of that index.
The effect is much greater in a narrow-based index such as the Dowthan in a broader index like the S&P 500, but with some of the leviathans ofthe NYSE even the broadly based indexes are at times vulnerable. As usual,Vinny and Denny were the ones to point out the importance of followingcorporate headlines as they were being made. By watching the newswire, itbecame possible to ﬁnd companies buying back their own stock or headlineswarning of a miss on earnings or a change in the company’s expectations.Aside from the world of arbitrage, there are other factors that drive themarket on a daily basis. Hedge fund activity can dominate the price actionon a given day when positions become larger than the market can handle atcertain times in the session. Many funds have based their trading on patternrecognition and the probabilities that are derived from the analysis. Thehigher the probability for a winning trade, the larger the position becomesfor the fund. This is a problem for many managers, as assets under manage-ment become so large that it is difﬁcult to create the same type of returnon equity that a similar strategy would generate with less money at risk.The effect of hedge fund activity is nowhere greater than in the differentagricultural futures markets found at the CBOT and the CME.
As funds look for more opportunities, they have begun to explore theonce forbidden world of agricultural futures and options. At ﬁrst, many of
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the institutional fund managers shied away from the old-time ag markets,leaving them for the commercial houses and the natural hedgers that neededthe products for price discovery. But as the amount of money under man-agement in the industry began to grow, so did the need to ﬁnd other marketsthat could foster the opportunities necessary for the fund to ﬁnd a proﬁtabletrade. It’s not uncommon to ﬁnd funds that trade everything under the sunfrom cotton and sugar to Malaysian palm oil. Most of the funds have beenforced to become global in their approach and have 24-hour operations totake advantage of the Asian and European time zones.
When I ﬁrst started in the industry in the early 1980s, the concept of ahedge fund was foreign, not only to the general public but to those of us inthe business. It wasn’t until the successes of legendary managers such asPaul Tudor Jones and George Soros that the ﬁnancial community woke upand began to realize what many of the endowments had already discovered:that investment in the proper hedge fund is crucial to the overall stability ofthe portfolio. What started as a trickle in the early days turned into a massivewave as the creation of hedge funds became the sweet spot for every majortrading house. The proliferation of these funds has become a double-edgedsword for the industry, as the sheer number of funds has shed more light onit. To the horror of many, Congress has decided that the growth in activityrequires its expert oversight.
What many off the trading ﬂoor don’t understand is that the size of thefunds could cause huge price swings in the market and traders who canidentify the wave can ride the wake created by the aberration, taking a niceproﬁt. Some traders will trade only when the funds trade, the logic beingthat they are doing the homework with hundreds of hours in research andcapital; therefore, any position taken by a large hedge fund is a calculatedbet. When reporting on television, I refer to fund activity constantly becauseI want people off the ﬂoor to understand the impact that the fund is having onthe daily volatility. The analogy I use is that a fund establishing or liquidatinga position is much like an aircraft carrier turning around in a small bay. Theanalogy is a good one because it helps listeners grasp how cumbersome itcan be for many of these fund managers to minimize their market impactwhen they are active.
Smart traders recognize the impact the fund is having, not only on themarket that the order hits, but on the ancillary markets that might be affectedby the primary. The growth in the industry has also created a problem inthat many of the funds that have sprung up over the last few years haveconsidered themselves alternatives, yet they have a strong correlation tothe stock of the bond market. This has made the term hedge fund a moregeneric way of describing assets under management. In fact, many refer toa hedge fund as a mutual fund that is allowed by charter to be short themarket. Remember, a true hedge fund will have a low or no correlation
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with the rest of the portfolio, and any investment that is not structuredto capture that part of the investment universe cannot be called a truealternative investment.
Another of the best-kept secrets on the ﬂoor is the impact that theclosing orders have on a session. More and more of the funds have startedto mark the daily activity on the closing bell of the stock market, whichcloses 15 minutes before the futures markets close. The creation of thesynthetic funds has been a blessing for traders who can identify the tradeand follow its impact as stocks close. Very often, traders will come backinto the markets at 2:30 PM Chicago time so that they can ﬁnd the closingorder and capitalize on the aberration it might create. These funds giveinvestors exposure to the equity markets through an investment in a fundthat ﬁnds a futures position as its largest holding. This synthetic marketexposure allows investors to garner more leverage and liquidity and givesmarket timers a powerful new tool.
Most of these funds mark the buy and sell orders against the close ofthe stock market, which creates a large trade at 3 PM Chicago time, the cashclose. The orders are executed in the market the same way every day, withsome managers asking brokers to work the orders a little early in order tobeat the race to the door on the bell. It’s the three o’clock order that makessome traders the most money day after day. The impact of these closingorders has become larger and larger as the products they represent havebecome an important part of the investment world. Smart traders will timethe orders and ride the price aberrations that are created by them. It’s almostas if the seasoned trader can sense a cash close order coming, especiallyon days when there are huge moves in the market.
CAPITAL FLOWS
The popularity of these types of funds have made it almost impossible tomove a large order on the close of the stock market without leaving a bigfootprint on the pricing taking place. Another problem for the funds is thatpositions seem to become concentrated, which breeds an even more volatilecondition when the orders hit the market. The end of the month also createssome excitement, as the traditional futures brokerage community, whichgets paid commissions monthly, inevitably covers customer positions, onlyto reestablish them the following month.
Another end-of-the-month anomaly is the settlement of the stock in-dex futures markets to fair value. This is done primarily for the syntheticfund managers, who get marked on their performance on the monthlysettlement. The exchange employed the practice because, too often, the
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action between 3 PM and 3:15 PM Chicago time skewed the fair value dueto the lack of an underlying cash market to keep it in line. The onlyother time during the day when it becomes critical to watch the clockis when the European bourses close. At roughly 11 AM Chicago time, wewitness the last of the European fund managers’ activity as they closeup shop or pass their global book on to New York for the evening. Thisis why there always seems to be a ﬂurry of activity around that timeof the day, as the markets feel the effects of bourse closes in a quietafternoon condition.
Another major factor in the daily price movement of the futures mar-kets is sector rotation. It used to be that equity traders would talk aboutsector rotation in the traditional way—that is, moving from one sector ofthe stock market to another. The concept of rotating assets has taken ona new dimension as we have witnessed the futures industry being viewedas a legitimate asset class. We still can see the effects of sector rotation inthe stock market by watching the price action in the large-cap stocks asit relates to the other indexes. Many times I will report what looks to be asector rotation that is done by watching the relationships in the intermarketspreads between the different stock indexes.
When the S&P 500 is strong and the Russell 2000 is weak on any givenday, it is a sign that there could be a rotation out of small-cap stocks intothe large-cap companies. When funds ﬁne-tune their equity exposure, theeasiest way to execute the order, if they are tracking against any index, isto use the futures markets and the efﬁciency they bring. But sector rota-tion has taken on a new meaning as managers have looked to commodityexposure as a necessary part of the portfolio. This has created an almostincestuous relationship between the world of basic commodities and theequity markets. Much of the recent run the world has seen in commodityprices has been attributed to cheap money and the rise in demand for thegrowth experienced globally.
ETFs
A byproduct of this tremendous growth has been the invention of theexchange-traded fund, which takes a basic raw material such as gold orcrude oil and transforms it into a listed equity. As managers allocate assetsaccordingly, they have begun to use the ETF market much more effec-tively. This growing audience for the commodities represented by the ETFshas created a new customer base for the old-time futures exchanges—thesmall retail stock traders who have never traded futures before. Most ev-ery ETF on the market today would ﬁnd it impossible to exist without
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a futures component that allowed the market maker of the product tohedge out the risk. That’s why the ﬁrst ETFs that came into existencewere created off the backs of the open interest and liquidity providedby the futures markets representing the underlying cash market. TheSPDR and the QQQ are perfect examples of products that experiencedsuccess in some way because of the risk management provided by themarkets in Chicago.
Too often, the market experiences movement that can be directly re-lated to the cash ﬂows that are invested on a monthly basis. It used tobe that a good trader would know that on the ﬁrst and ﬁfteenth of everymonth, institutions put capital ﬂows to work so that they can be true totheir investment strategy. The ﬁrst and ﬁfteenth represent the pay periodsin which retirement money and investment dollars are available for expo-sure in a given asset class. This has been a consistent theory for those whotrade equity futures, but that hasn’t been the case for those in the tradi-tional physical commodity markets. The large sums of retirement moneyhave always seemed destined for the stock or the bond market, but therecent acceptance of the ETF market has changed the nature of the trade.Investment dollars are sent into many of the ETFs, which have, as theirunderlying component, exposure in a given commodity.
The recent run-ups in the gold and crude oil markets can, in some way,ﬁnd their genesis in the speculation brought on by the ease of buying therepresentative ETF. These days, smart traders watch the fundamentals of agiven commodity and the cash ﬂows in and out of the ETF they representin order to take advantage of the twice-a-month trading opportunity. Manyin the investment community are starting to become very concerned aboutthe proliferation of the ETF concept among the trading public.
One of the main concerns involves the lack of education on the part ofthe investors sending in retail orders in order to get commodity exposure,something most investors want. But few ETF investors realize that if theywere to either do their homework or ﬁnd a good broker who understands thefutures markets, it would be much more cost effective to put on a syntheticfutures position that has huge leverage rather than tie up capital in an equityposition that has none. It becomes a question of smart money managementand where the capital is better used.
Monthly timing is smart, but even more important is to know at whattime of the intraday session to ﬁnd an opportunity. Back when I was workingwith the index arbs, Vinny and Denny taught me that at 2:40 PM Chicago time,some 20 minutes before the close of the stock market, stock imbalances areshown to the world in order to ﬁnd an orderly way to correct the imbalancerather than have a surprise ending to the session. This is precisely why themarket has one ﬁnal move at the end of the day. I ﬁnd it odd that so manytraders who put large sums of capital at risk daily have no concept of the
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order imbalances at the end of the day or the effect they could have on theclosing price action. It’s funny how no matter what they were doing, bothVinny and Denny would get on the phone together, using me to do the arbin various markets simultaneously, as the imbalances were released.
I found that there was a great trade if the imbalances were large enough,and more important, they would give me an idea of what stocks were in play.I came to understand that the larger the capitalization of an indexed equity,the greater the effect of the imbalance on the closing price action. Anothervariable to the 2:40 PM trade is that many of the market makers on the ﬂoor ofthe NYSE and other equity exchanges are asked to cover some of their shortposition by the ﬁrms that clear their daily trades. On a day when the priceaction is one-sided, this late-day phenomenon gives experienced traderstwo different opportunities for a high-percentage trade: They can play thereversal in the price action by being contrarians to the daily trend or theycan wait until the imbalance effect is ﬁnished and reestablish the originaltrade.
The question most often asked of me is what the professionals arewatching during the course of the session that might give them an insightinto the next trend. If you were to ask 10 different traders what they watchon a consistent basis to give them the needed conﬁdence to establish aposition in the market, chances are you’d get 10 different responses. Themarket has become very dynamic and the things that seem important todaymight seem irrelevant tomorrow.
A good example is the way the stock market used to treat the release ofthe money supply ﬁgures during the week. The Federal Reserve issued theﬁgures at 3 PM, 15 minutes before the futures markets closed. Many traderstoday got their start by being clerks during the infancy of the S&P 500 pit,relaying the money supply ﬁgures to their customer desks as they werereleased. The stock market, sensitive to the inﬂation-ﬁghting Fed of PaulVolcker, had many violent reactions to the release of the ﬁgures. Today’straders have very little need for money supply but will ﬁnd a fundamentaldirection in the market by watching what they think the Federal Reserve iswatching.
WATCHING THE RUSSELL INDEX
Another well-kept secret in the investment world is the impact of the small-cap stocks as measured by the Russell 2000 and the leadership they’veshown through the last few years. Many experienced equity traders havecome to realize that the market has a difﬁcult time moving in either directionif the Russell doesn’t comply.
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To get a better understanding of why the small-cap universe has becomesuch an important factor in the movement of the daily price action, you mustgo back to the catalyst—the 2004 Jobs Creation Act passed by Congress,which was looking to free corporate capital held in oversees subsidiaries ofmultinationals. This act imposed on the companies in question a one-timeﬂat tax of 5 percent on all capital repatriated to the United States. Over thecourse of 2005, the dollar seemed to defy logic by staying strong, while allthe experts looked for a complete implosion of the currency.
The act was very speciﬁc in its intent: to expand the research and devel-opment teams of the corporations and help create jobs. It was not intendedto be used to buy back company stock or issue large dividends to share-holders, but it did free up capital expenditure dollars that were budgetedfor R&D, which were redirected to internal use.
There were two important ancillary effects the Jobs Creation Act had onthe way the market moves. First, the dollar had natural support around theglobe, as the swap market for any currency into dollars was the most activeit had been since the creation of the euro. As companies repatriated capitalfrom the foreign subsidiaries into the U.S.-based headquarters, the demandfor U.S. dollars skewed the entire Forex market, creating a difﬁcult situationfor the traders not following legislative activity in the U.S. Congress. At atime when the dollar was under tremendous pressure, moving some 30percent lower against the other major global currencies, it was Congress,of all things, that came unknowingly to its aid.
The second and more important effect of the act on the stock marketwas the way it fed into the supply chain. The small-cap universe is repre-sented by many of the companies that are directly in the supply chain ofthe corporations that repatriated capital back to the States. These smallercompanies became the direct beneﬁciaries of much of the freed-up capitalthat came back home.
This is one of the main reasons that professionals have started to watchthe Russell index regularly and, taking it one step further, have realized theimportance of having the small-caps participate when the market moves.I have come to believe that the Russell index is the best indicator of theoverall health of the stock market. Many might look at the S&P 500 orthe Dow for a clue about how the economy feels, but those who understandthe changing market structure have begun to watch the Russell very closely.The Russell stocks represent the suppliers, and the suppliers to thesuppliers—this incestuous relationship with the larger-capitalized compa-nies has drawn much more attention to the small-cap universe than everbefore. It has become a leader for the entire market on the way up andon the way down. It has also become a place where the larger-capitalizedstocks have a difﬁcult time moving higher if, in fact, the smaller-cap stocks,as measured by the Russell 2000, move lower.
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Know your market. Those words are as true today as they were whenRalph Peters said them to me over 25 years ago. But one of the most impor-tant things to keep in mind is that the market does not remain in a staticcondition; on the contrary, it is very dynamic. By nature, the condition ofthe market changes with the technology and the participants who makeup the daily liquidity. Many remain in the dark about the various types ofarbitrage or the timing of certain daily events but still ﬁnd it necessary to riskthousands of hard-earned dollars on positions that are totally speculativeat best.
It’s only by becoming a student of the markets that you can acquirethe knowledge needed to be a good trader. The best in the world have theability to shut out the noise of a session and tune in to the market with fullfocus and attention. As Bing said to me, there are 2,000 different lessons tobe learned about trading. However, I have found that the daily observationof the price action and the factors that drive the action teach more lessonsthan any single act. There are no books that teach the role of the differenttypes of arbitrage and the market-maker activity that drive volatility. In fact,it was the lack of material about the fundamentals of the daily price actionthat led me to believe that the most important thing I could contributewith this book would be to give the average investor an insight into thenuances that are an important part of the market structure.
I have never read anything that might offer me a clue about how topick up an asset allocation or a series of buy or sell orders hitting themarket; it’s only through watching the trade day in and day out that theunwritten rules of the market become obvious. For a trader, understandingthe changing nature of the market is a necessary survival mechanism. Thelatest and most recent test for the ﬂoor trading community is the revolutionof electronically traded futures and options and the migration of liquidityaway from the open outcry session. This dynamic event has forced manyof the old faithful ﬂoor traders to evolve into a hybrid of sorts, remaining inthe pit but trading most of their positions electronically.
This concept of creating an electronically traded futures contract basedon the open interest and liquidity provided by the larger, more establishedcontract has revolutionized the game and contributed more to the industrythan any single event since the design of ﬁnancial futures in the early 1970s.We are in the infancy of a ﬁnancial revolution that will change the face offutures trading forever.
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ManagedFutures: TheHoly Grail
T he year 1989 was very tough for someone trying to make a living
trading anything equity-related on the ﬂoor of any exchange aroundthe country, but it was especially difﬁcult for those of us in the S&P500 futures pit at the Chicago Mercantile Exchange (CME). The New Yorkregulators, not understanding the nuances of the derivatives markets, hadcome to blame the 1987 stock market crash on stock index futures, whichhad begun trading as a new concept in the early 1980s. As it turns out, thestudies exonerated the products and showed that futures not only didn’tbring down the stock market but acted as a buffer for all the selling pressurethat a deteriorating fundamental condition brought forth. It was the onlymarket left open for a world rife with panic and fear.
Many—myself included—are convinced that the futures market helpedsave the entire ﬁnancial system. The effects of the crash, regardless of theultimate result years later, created an environment that made order ﬂowin the equity futures pits scarce and institutional use of the products arare thing. Battles among the various government regulators in Washingtonbrought about an era of tension and alarm not seen in the industry beforeor since. The regulatory uncertainty that surrounded the product madeselling or brokering the market so difﬁcult that many who had created anice business for themselves soliciting and servicing S&P day traders wenton to other, more familiar markets such as the Eurodollar futures at theCME or the ﬁxed-income pits of the Chicago Board of Trade (CBOT).
As a trader, I found that the prosperity of the pre-1987 market was slowto return. When United Airlines (UAL) announced disappointing earnings
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in the fall of 1989, I was caught long the S&Ps and watched as stocks brokedown in a huge percentage