Spark Global Limited Reports:
Today’s market is completely electronic.
You generate a digital order ticket and send it to an electronic exchange, which automatically matches your order with the corresponding one, or it sits on the digital order book and waits for another trader to send an order that satisfies it.
Apart from some problems caused by high-frequency traders, everything was so elegant and efficient.
But what about before everyone had computers? What was it like before?
There are floor traders.
These are members of a physical stock exchange, who take orders from clients over the phone, are obliged to trade against orders, or find another trader on the floor to do the other side’s trade.
For many young traders like me, seeing these guys pushing each other around the hall screaming “Buy, sell!” “There’s no obvious rhyme or reason behind it.
Old trading books like “Market Wizards” are filled with interviews with highly successful floor traders who explain their time-tested trading principles that have brought them great wealth.
Cutting your losses quickly and adjusting your bets effectively, the trend is that your friends are the mantra of these traders, but how do they generate trading signals?
What about technical, fundamental or quantitative analysis? How did these traders profit by standing in a pit and making verbal trades with minimal analysis?
The trading edge on the floor
However, the question remains: how do floor traders gain trading advantages?
Today, electronic traders may use technical patterns, fundamentals, sentiment analysis or elaborate statistical arbitrage strategies to find trading advantages and trade on them.
For the most part, floor traders don’t have much analytical or computational power, so is this just gut feeling? Part.
The main way floor traders gain an edge is through market making.
In most cases, they buy at bid, sell at asking and collect the difference. They do this many times throughout the day, while managing their inventory to ensure they don’t get too long or too short on the market side.
They make an immediate profit on almost every trade by earning the bid price/bid price spread. Do this enough times that it doesn’t really matter how you generate trading signals as long as you’re managing risk.
William Eckhardt, best known for his famous bet with Richard Dennis that led to the birth of Turtle Traders, had this to say about the advantages of floor trading:
Otc traders live or die by what they think about the market or the system. Not so for floor traders. As a floor trader, you just need to be able to tell when the market is out of line, or a few lines. Once you master this skill, whether your theory is sound or not, you are likely to survive. In fact, I know many bitcoin traders who subscribe to all sorts of phony systems: moving averages, moon cycles and god knows what. When they get a signal from these systems, they basically buy at bid or sell at bid. At the end of the month, they have a profit and they always attribute it to their system.
Basically, floor traders have a lot of fancy ideas and systems, but most of the time you can reduce their advantage to the point that they earn the bid-ask spread on most trades.
Since most floor trading is pre-decimal, the spread is quite large, especially when you trade on a large scale.
So as long as you always buy at bid and sell at bid, you can only trade when the second hand on your watch is prime, generating a trading signal and still making money.
Moreover, markets were much less efficient before transactions went electronic. Securities are often structurally mispriced because traders and portfolio managers in general do not know how to value them properly.
“A trader with the most basic knowledge of option pricing theory can take advantage.” In the land of the blind, the one-eyed man is king.”
That’s how superstar trader Linda Raschke started trading on the Pacific Coast Stock Exchange.
Rather than perform the complex math needed to derive the theoretical value of Black-schools options, she uses the intrinsic value as well as the history and expected volatility of the underlying securities to determine whether options are mispriced.