als on one side of the trade and more than likelyuses a contrarian’s strategy by selling into a rallying market or buying intoa breaking one. Spreaders, in contrast, come in and move one leg or seg-ment of the market, depending on what happens in the secondary leg of thespread.
For example, when the rollover condition takes place four times a yearin the S&P contract, large, bulky orders come into the deferred month, whichis less liquid, creating what looks to be a feeding frenzy and forcing spreadersinto the front month, driving prices out of whack. It’s the inefﬁciency of themoment, which most spreaders will ﬁnd proﬁtable. This happens every nowand then, usually on the open or close of the session, but it’s very signiﬁcantbecause it’s a prime example of one segment of the trading populationdirectly affecting another.
I can’t tell you how many rollover conditions in the S&P 500 futurespit I brokered and traded as price anomalies produced opportunities forspreaders to quickly lock in huge proﬁts within seconds. Each one of thesegroups understands the importance of monitoring and assessing what thevarious other groups of traders are doing. Some of the best position tradersI know will tell you exactly what they see happening in the options marketsas a result of the indirect impact any large options order might have on thepricing of the underlying. This can give you a fairly accurate gauge of whatside of the market the scalping community has concentrated their efforts on.Most traders, regardless of the style they have chosen, become victimsof the need for instant gratiﬁcation. This is the common denominator foundamong all traders on the ﬂoor of any exchange. I discovered this addiction
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to instant gratiﬁcation ﬁrsthand, when as a local I found it very difﬁcult toslow my pace after the closing bell had sounded. After I left the tradingﬂoor each day, the world outside the exchange seemed to be moving inslow motion compared to the hectic frenzy of the CME. I found it hard toturn off the energy and go back to being a father and husband in a quietbedroom community outside of Chicago. Even worse, I knew that everyinvestment I made would be judged by the risk-to-reward ratio that tradinghad automatically given me, which is a recipe for disaster.
It became much more difﬁcult to invest my assets for a 10- or 20-yearhorizon when I felt the future was now! Think of how boring a real estatetrust or a tiered bond portfolio sounds when you compare it to the possi-ble returns in futures. It became apparent to me that the need for instantgratiﬁcation was starting to skew my perception of reality, which can bevery dangerous when you are dealing with your personal net worth on adaily basis. This is one of the main reasons that scalpers and high-energyﬂoor traders have found it difﬁcult to migrate to the world of the “upstairs”screen trader.
For those who entered the industry at an early age, as I did, the cultureand camaraderie found on the exchanges were hard to duplicate when theyleft the ﬂoor during the electronic trading revolution. For ﬂoor traders tosuccessfully transform themselves into good screen traders, they must leavethe ﬂoor behind and be educated afresh as traders. Bing advised me not toget too cerebral about the markets when I was scalping. Electronic daytrading requires traders to maintain a pulse on the markets and keep upwith any information that might send price action into a volatile condition.The big advantage is that these new electronic traders can now monitor andtrade many markets simultaneously, whereas in the past it was impossibleto watch more than one or two effectively.
Traders whose entire careers were spent looking up at a wall board withprices and headlines experience culture shock to ﬁnd themselves upstairsstaring at quiet screens with a TV on mute and positions that seem almostemotionless at times. The hardest thing for these new traders to overcomeis the feeling of helplessness because they are at the mercy of the aggressoras participants on the electronic platform. Most ﬂoor traders had cometo regard the right of ﬁrst refusal as inalienable when they were creatingliquidity in the pits. Now, however, the liquidity provider stares at a two-dimensional screen with no hope of monitoring the order ﬂow or gaugingthe collective position of the pit community. There’s a new mantra for ﬂoortraders that every veteran of the pits has memorized: Change with the timesor perish!
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C H A P T E R 3
Know Thy Market
S ometime after my inaugural trip to the Chicago Mercantile Exchange
(CME), a college friend who wanted to ask his godfather for ﬁnancialassistance asked me for a ride to the North Shore of Chicago, one ofthe wealthiest residential areas in the country. As we approached a streetlined with the biggest mansions I had ever seen, he instructed me to turnin at an enormous house on the shore of Lake Michigan. I was reluctant asI made the turn, convinced that my friend had pulled a fast one by makingme turn there. It quickly became apparent that this was no joke and thehouse we were about to enter belonged to his godfather, who happened tobe Ralph Peters, the chairman of the Chicago Board of Trade (CBOT) atthat time.
As a new member of the capital markets/traders fraternity, I was given aquick education on the biggest players in the city and how they acquired theirwealth; Peters was my ﬁrst lesson. Peters was a visionary on the Chicagomarket scene, having been one of the pioneers in the use of technology intrading. Tall in stature, Peters likewise had a reputation as a large trader, inaddition to what many would call his greatest asset: Nerves of steel.
Peters had made his fortune many times over. One story that standsout concerns the original wealth he created in the soybean market duringthe Cuban missile crisis. He stepped into a soybean market that had beenin a limit-up state for days due to the impending situation in which Sovietmissiles would be positioned in Cuba; he established a maximum shortposition.
He had come into a market that had been going straight up for aweek, and he sold everything the exchange rules would allow. Being in
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a limit-up state, the market was very accommodating to Peters, allowinghim to sell as many contracts as he wanted—after all, there was a threatof a nuclear conﬂict over the weekend, and anything could happen. Whowanted to be short in such a situation? Soybean traders gathered aroundand watched in amazement as he carefully and meticulously carded eachtrade he made in the pit. When asked why he was putting so much cap-ital at risk under tense market conditions, his reply was classic: “ComeMonday, I’ll either be dead or the richest trader in the pit!” The rest is his-tory. The Soviets withdrew the ships and the soybean market was limitdown for days.
Peters, out of respect for the market that had provided his fortune,bought an estate on part of a key in the Bahamas and named it Soya Beana.Wow! Imagine the guts it takes to do such a thing! The ﬁrst time I heardthis story was as I was driving his godson, my friend, to his house that time.When we entered the house, Peters was sitting at his large desk. Withouttaking his eyes off his trading screen, he suddenly asked me whether I wasgoing into the markets, as was his godson. I said no, that I was thinking aboutgoing to law school and pursuing a career in law or politics. He sprang tohis feet, towering over me, and said, “Kid, forget law, go into the markets.It’s the most overpaid business in the world! But whatever you do, knowyour market!”
As I left that house, I remember giving serious consideration to a careerin the capital markets for the ﬁrst time. When a man as successful as Peterstells you one of the secrets to acquiring wealth, it might be a prudent thingto heed his advice. Years later I became acquainted with Ralph’s son, whohad become a trader in the S&P pit at the CME. We would occasionally havelunch and chat about markets and the characters who made our professionso colorful. During one of our lunches, the subject of the Cuban missilecrisis and Peters’s soybean trade came up. His son asked me what I hadheard about this story.
With a twinkle in my eye, I told the story that I had told countless timesat parties and business functions. I could see Peters’s son leaning backwith a big smile on his face. After I ﬁnished the story, he leaned forwardand said, “Is that what you heard, Jack? Well, now I’ll tell you what reallyhappened.” As it turns out, Ralph never made a large trade without doing hishomework and gathering all the information, and the classic soybean trade’was no exception. He had a vast network for information that stretchedfrom California’s Central Valley to the halls of Congress in Washington,D.C. His contacts in the diplomatic community gave Peters the word thatthe ships had indeed turned around and the Cuban missile crisis had beenaverted. Know your market! It had been 10 years since Ralph Peters haduttered those words to me, but it was then that I fully understood what hehad meant. Information is gold. Or as Bing Sung taught me later, don’t make
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a trade without knowing the whole story, Ralph died a few years ago, buthis stories and market exploits have become legendary.
KNOW YOUR MARKET
“Know the market that you trade” is perhaps the best advice I have everreceived from anyone. Having the power of information allows the traderto establish positions with conﬁdence and understand the true nature of therisks associated with the trade. To understand the power of this tool, it’simportant to understand how you acquire knowledge. The biggest secretsamong traders lie in the everyday factors that drive daily volatility and theway you work the volatile nature of the market to create high-percentagetrades.
ASSET ALLOCATION
When I do my daily market commentary on Bloomberg TV, I often talk aboutasset allocation models and the effects a shift in the model have on the dailyaction. Simply put, an asset allocation is the redistribution of assets fromone class to another. To make our examples easy, I’ll describe a basic assetallocation strategy and the tactical approach that ﬁne-tunes the positions.Many fund managers have models they make known to their investors thatshow the percentage of assets in stocks versus bonds, the largest portionof the portfolio.
The strategic model of an asset allocation shows the overall percentagesof the fund, for example, 50 percent in stocks, 40 percent in bonds, and10 percent in alternatives. The tactical adjustment would take a percentageof assets from, say, stocks, and transfer them into bonds or alternatives. A5 percent tactical shift in the asset allocation of the example given wouldcreate a portfolio that might end up looking like this: 55 percent stocks,35 percent bonds, and 10 percent alternatives. But the questions remain,how do you identify when a trade is being done and, more important, howdo you proﬁt from the situation?
At times we have witnessed large, strategic institutional asset allocationtrades hitting the market. These are huge positions that take days to accu-mulate and have enormous staying power because of the passive nature ofthe investment. Working with Nikko, I would occasionally be involved withone of these large strategic trades, which required days of moving hugeorders into the market with as little impact as possible. The trades were inthe $1 billion to $5 billion range, with most of the activity centered on the
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equity markets and the ﬁxed-income market. The orders would come in tobuy S&P 500 futures and sell the 30-year bond, and the orders would comesimultaneously!
It didn’t take me long to ﬁgure out that there was a pattern devel-oping with every order I received. Not only were we buying in one mar-ket, but we were selling just as aggressively for the client in the ﬁxed-income bond futures. Every half hour we would get the order to buya large quantity of S&Ps, and as I would quietly place my orders intothe equity pit, I would notice selling pressure in the bonds. The more Idid those asset allocation orders, the more I realized that the opportu-nity existed for the sharp trader to capitalize on the aberrations createdby the size.
The Japanese seemed to do things in tandem; therefore, if Nikko wasexecuting an institutional asset allocation order in that manner, so wouldNomura, Diawa, and every other large Japanese brokerage house of thetime. As large as the strategic orders would get, it’s the tactical appli-cation to the overall asset allocation model that drives the market on amore frequent basis. When I report the evidence of an asset allocationin the daily trade, I’m usually referring to a tactical AA that drives themarket on a short-term basis. Often I’ll notice that the orders stop at ap-proximately the same time that the European fund managers are leavingfor the evening. Although they all have operations that run around theclock, a large portion of any such order is completed by the close of theEuropean bourses (exchanges).
It’s also important to try to identify the type of maturity that is in-volved in the trade because it allows the trader to watch as the ordercreates a market impact. The role of the broker, or brokers, in an as-set allocation order centers on the execution of the trade and the slip-page and market impact they create when entering or leaving the market.One thing is for sure, not all brokers handle the large asset allocation or-ders the same way; in fact, traders will tell you that some large broker-age houses tip their hands by using time orders or other easily identiﬁ-able tactics. The shrewd trader will quickly realize that there is ampleopportunity for proﬁtable trades when the order is handled by the lesscapable brokers.
Many times the markets involved in the order move in opposite di-rections at the same time. It becomes obvious to the seasoned veteranof the markets when waves of buying come into the equity markets asselling pressure hits the 10- or 30-year bond futures that an asset alloca-tion is being executed. The only question for the trader is whether theorder’s origin is domestic or foreign. Identifying the source of the trans-action is important because it gives the trader an indication of whenthe order might be complete. A European or Asian order is usually
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75 percent complete by the time Europe closes, around 11 AM Chicagotime. A domestic order, however, will continue into the bond close at2 PM U.S. central time, and at times will continue electronically well past theclosing bell.
FOREX-RELATED ASSET ALLOCATION
Equities and ﬁxed income are not the only asset classes used in an allocationmodel. In some cases, the asset allocation involves the currency marketwith direct relationships that spill into the commodities markets. As we’vewitnessed the creation of a new European currency, the need to managerisk between the dollar and the other major currencies of the world—yen,pound sterling, euro, and now the yuan—has never been greater. The globalnature of the markets makes the Forex market the most dynamic assetclass the investment community has seen in decades. Because of the highlevel of participation of the major money-center banks of the world, the vastliquidity within the currency market has provided opportunity to traders andinvestors alike. Many of the orders that involve the Forex market come fromforeign sources of capital, which use the dollar as a discounting mechanismwhen they search for value in U.S. equities.
Simply put, European fund managers will buy U.S. equities as the dollarweakens, hoping for two possible scenarios: a rising stock market with thedollar under control or a stagnant stock market coupled with a rally in thedollar. The logic is that any appreciation in the currency gives the Europeanfund manager a proﬁt even if the market goes sideways because of the Forexexposure, or if the market were to appreciate, they would see an even betterreturn on capital. Fund managers can use this strategy both for a decliningdollar and for a rising dollar; in both cases, the volatility created by theglobal currency markets drives the trade.
The ﬁrst time I became aware of a Forex-related asset allocation waswhen I was with the Japanese at Nikko. The huge swings in the dollar-yen market of the late 1980s and early 1990s gave the global institutionalmanagers fodder for trading methodologies that have grown into one of themost inﬂuential institutional strategies in use today. At the time I rememberthinking how creative it was for these ﬁnancial engineers to construct tradesthat had a currency component that created opportunity for proﬁt in so manydifferent ways. Because of the nature of the cash Forex market, much ofthe volume is done there as opposed to the futures markets.
In the equity-ﬁxed-income AA, the futures markets are the vehicle ofchoice because of the speed and efﬁciency involved in the use of the prod-ucts. Think how difﬁcult it can be for a fund manager who has an AA order
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to sell every stock in the S&P 500 rather than sell a basket of futures andexchange the position for the stock in the EFP (exchange for physical) mar-ket. This EFP market allows the position to be transformed from one in thefutures market for the actual stocks that compose the index. This nuance inthe market gives the fund manager the speed and efﬁciency needed whenhandling vast sums of money.
The larger the amount of capital under management, the more difﬁcultit becomes for the institutional trader to execute the order. The futures mar-kets allow the traders the ﬂexibility to use derivative forms of the underlyingmarkets with the leverage and liquidity they need. As an institutional bro-ker, it became vital to identify the asset allocation as it drove the market ineither direction because the natural momentum of the trade created a pathof least resistance, which became valuable information. Using the upsideor downside pressure created by any type of AA to the clients’ advantageseparates the good brokers from the bad ones.
When I’m reporting on the various business TV programs during thecourse of the session, I will point out what I think might be an AA in eitherthe equity-ﬁxed-income world or involving what looks to be a currency play.I tell the viewing public how important it is for traders to let the volatilitywork in their favor. Let the pressure that is brought on by large ordersbring the market to the individual as opposed to chasing a rally or break. Itbecomes a question of patience.
When Bing ﬁrst educated me on the concept of asset allocations andtheir effect on the daily movements of the market, he used a line he hadborrowed from a coworker at the Harvard Management. Whenever he iden-tiﬁed an AA, he would place orders above and below the market and tellme, “Patience comes to those who wait!” As strange as it sounded at thetime, the lesson he taught me was as clear as it could be: Let the marketcome to you!
INDEX ARBITRAGE
I was introduced to the nuances of index arbitrage by the ﬁnest teacherstrading the strategy at the time, Vince McLaughlin and Dennis DeCore. Vinnyand Denny, as they were known to the pit community, started trading indexarbitrage at Merrill Lynch when index futures were born in the early 1980s.Even before I met them, Vinny and Denny were legends in the business,having taken index arbitrage from being a quaint trading strategy to beingan art form that many would copy.
Vince is a New York Irishman with an afﬁnity for Celtic music; the storyhas it that he traveled around Ireland as a youth, singing for his traveling
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expenses from pub to pub. Always a quick wit, Vince was perhaps thebest storyteller I ever came across. I would listen to him for hours at atime when the market was slow, laughing at the insane characters he de-scribed in his yarns. What made them all the better was that they wereall true—every one of the colorful characters actually existed, and someare still alive today.
Denny was the perfect complement to Vinny. When Vinny would getemotional, Denny would be the epitome of calm and serenity in an otherwisestressful environment. Denny, originally from Trenton, New Jersey, grew upin a working-class Italian neighborhood. He took the lessons learned fromthe rough streets and coupled them with an innate gift for logic and numbers.If ever a trader combined the cunning instincts of a great riverboat gamblerwith the opportunity the market provided, it was Dennis DeCore. WhatVinny and Denny did for one another was balance the emotional volatilitythat runs with trading the markets. Whenever Vinny would get excited,Denny would calm him down. Whenever Denny needed to get excited aboutsomething, Vinny would work him up.
Index arbitrage is a strategy that takes advantage of the discrepancybetween the cash market and the futures market. The action taken by thearbitrageurs is determined by whether the premium—that is, the spreadbetween cash and futures—is cheap or expensive according to their calcu-lations of fair value. Fair value is a dynamic number determined daily by acombination of a several different factors: time till expiration, dividend ﬂow,and the cost of capital that you are charged as an institution. The terms buyprogram and sell program were derived from the vocabulary of the arbs,which changed the nature of liquidity in the markets forever.
I began working with Vinny and Denny after they had left MerrillLynch. Before I started, I was warned by their former clerk not to asktoo many questions at ﬁrst because it might give them cause for con-cern. At this time in the industry, the kind of proprietary trading knowl-edge that Vinny and Denny possessed, and had left Merrill with, was morevaluable than gold.
I understood that if I was to learn anything about what they weredoing, I would have to be slow, cautious, and deliberate in my inquiries.The action of the arb takes concentration on many parts, especially theﬂoor, where identifying the price aberration before it begins allows thearbitrageur to react that much more quickly. As they became more andmore comfortable with me, I would spend the entire session on the phonequoting the market and acting as a color man to the players in and outof the pit.
The more time I spent on the phone with either Vinny or Denny, themore I would overhear about what they were doing and, more important,why. After the ﬁrst couple of years with them, I became conﬁdent that
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I could ask almost any question and get an honest response. To my surprise,as they became more comfortable with me, they became mentors, teachingme the little things about their end of the business that regularly affectfutures.
NUANCES OF INDEX ARBITRAGE
Of the hundreds of lessons that I learned from Vinny and Denny, the threemost important things that can be easily understood by individual investorsare basis levels, EFP activity, and rebalancing the indexes. To many veteransof the market, it might sound strange that I would pick these three factorsabove all the rest, but I’ll explain the importance of each and how individualinventors can proﬁt from the information. The basis levels in the marketshow traders the spread between cash and futures. The basis can be apremium, whereby the futures trade above the cash price, and they canalso go to a discount, such as we saw in 1987, whereby the futures marketactually trades lower than the underlying cash market.
In the morning most business programs report what they consider to befair value for the day. When the trading session begins, it becomes vital towatch the spread between the cash and futures in order to gauge the affectsof the computer-driven buy and sell programs being done by the arbitragecommunity. By observing the spread, or basis, the skilled trader can tellif pressure is igniting programs or if the price movement in the market ishappening without the beneﬁt of the arbs. When the market is breaking,the basis becomes a reliable indicator of the action of the arbs and howthe market digests the programs hurled at it. Many day traders watch theprograms hit the market and play the wake created by their actions.
Most index arbs ﬁrst put on the futures position before sending orders tothe underlying stock market, but a few put one side of the trade on withoutthe other. This is not true index arbitrage, where the trades are made almostsimultaneously. It’s called legging the spread, but it’s really speculating onthe outcome. There’s an old saying on the ﬂoor: When you leg your spreads,it’s like spreading your legs—the same thing can happen. Vinny and Dennytaught me never to leg the spread unless absolutely necessary. Remember,they were the ones who used to tell me they placed their manhood in a sealedjar in the coatroom when they walked into the ofﬁce in the mornings.
Paying attention to the basis also gives traders a hint about if and whenthe market might turn in the opposite direction. In a breaking market, shouldbasis begin to widen out to the point where buy programs would be ex-pected, the index arbs could be responsible for stopping the break. Theopposite is also true: In a rallying market, should the basis become cheap,the arbs orders would stop the rally in its tracks.
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The second important lesson for any new trader to understand is theEFP activity that takes place in the index arb universe. The EFP marketallows the arbitrage community to ﬂip the positions from cash to futures,and vice versa. It’s important to note that an index arb needs inventoryin order to make money at the strategy. Inventory comes to the trader inone of two ways. The ﬁrst is that traders must wait until the market givesthem an opportunity for acquiring the inventory by trading with a rich basis.That is, the markets are trading with a premium level that allows the indexarbitrageur to sell the futures and buy the underlying stock market. Thisaction creates inventory and makes the arbitrage position a de facto indexfund.
The other way inventory can be found is in the EFP market, whereany institutional account can ﬁnd a market for the other side of a futurestransaction. Why is inventory such an important factor? When arbs are outof inventory they refer to the situation as being “out of bullets.” Without theammunition to trade a breaking market, the arb is left with a cumbersomeshort-selling technique that is not nearly as efﬁcient or proﬁtable as thenormal sell program.
I realized the importance of this information when, while working withVinny and Denny, I noticed that no one around the marketplace was doingsell programs even with a basis that showed the programs would be prof-itable. Not only were Vinny and Denny not doing anything, but as I lookedaround the pit no one was entering orders below the market. Something waswrong! I quickly called the boys and asked them if there was a computerglitch in the New York Stock Exchange (NYSE) system, but the answer wassomething I did not expect. “The Street is out of inventory,” Denny told me.As soon as the words were out of his mouth, I noticed buy programs com-ing into the market at levels that seemed to break even at best. I realizedthat the arbitrage community needed to put on the inventory, and that somewere willing to lose a little by putting the positions on, hoping to capitalizeeven more when covering the trades during a breaking market.
REBALANCING THE INDEXES
During the few times a year when we witness a rebalancing of the indexes,the opportunity for a high-percentage trade is never better. Listening toVinny and Denny during an announcement of a rebalancing was the equiva-lent of listening to two children who ﬁnd out that Christmas is arriving early.The act of taking one stock out of the index for some reason—bankruptcy,buyout, whatever—and replacing it with another more proﬁtable companycreates a condition in the market that gives those who do their homeworka natural high-percentage trade.
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The recent addition of Google to the S&P is a perfect example of theway the markets digest information. Upon learning that Google was beingadded to the S&P 500 index, I advised our brokers to tell their clients thatthe natural trade was to buy Google Nasdaq 100 or the Russell 2000 and sellthe S&P 500. The logic is that the hundreds of billions of dollars that areindexed against the S&P 500 must make the changes so the portfolios undermanagement don’t have any tracking errors. Many of the index funds must,by charter, make the changes on the close of business, as the rebalancing iscomplete. I immediately told the listening audience on Bloomberg that thiswas the trade of the month, if not the year.
Many of those who took my advice made a tidy proﬁt, as the marketdid exactly what one would expect: Google went up for days along withthe Russell and Nasdaq, and the S&P 500 stayed ﬂat. I ﬁrst became awareof the play when, during the amazing run in the tech market in the late1990s, JDSU was added to the S&P. This was at a time when technology wasking and any large addition to the index would create a giant wake fromthe index funds. Following the announcement that JDSU was being placedinto the index, I could hear Vinny and Denny buying the stock quietly andselling what appeared to be the SPDR ETF against it. In short, they werebuying the JDSU and selling the rest of the S&P 500 against it. Finally, afterlistening to them for hours talking about the situation among themselves, Iasked what was happening and why. That’s when I learned about the besttrade the market can ever give a trader.
CORPORATE EVENTS
Ever since that fateful day, I have played the addition to the index the sameway that Vinny and Denny did and have found that the proﬁt potential inthat situation is greater than that from any other single phenomenon in themarket. The opposite can be true also. Microsoft found itself on the otherend of the trade when it announced a large one-time dividend of $30 billionthat was to be paid out to share