Edge – the advantage of professionals or why we need an edge when trading

In the moment the screens stopped flashing when the market closed, at exactly 1600 hours Chicago time, and in the second before I looked at my profit and loss figure, the only thing that was going through my mind was – I hope the people in Louisiana are ok. The day was 31.08.2005, the first day everyone realized how devastating hurricane Katrina is, the storm that hit Louisiana two days prior. News outlets reported that thousands of people in distress and showing image of entire neighborhoods flooded. The markets were extremely volatile, and I hadn’t moved my eyes away from the screens the entire day. I was trading for a local fund for just a few months, but in this moment, I knew I had my best day yet. I looked – 2625 dollars. I was ecstatic, filled with satisfaction and slightly proud of myself… a few months later this would be considered a mediocre day.

As a professional market-maker (MM) I learned that to be successful you need to have an edge, an advantage when trading. If you do not and continue trading, you will lose all your money. Every slight edge moves the probabilities in our advantage and gives us a chance to get out of a trade for scratch (not lose) or small loss, if the trade is not a winner. The professional traders have many edges, but here I will give a few examples of what amateur traders don’t have.

Market and order edge of market-makers

MMs are traders in a product, or many products simultaneously, who are ready to buy from any sellers in the market and are ready to sell to any buyers in the market. They do this at prices and volume chosen by them (or by specific exchange requirements). MMs are like an exchange bureau – they have a bid and an ask for many currencies at the same time. They have a few key advantages in the markets they operate – access to many products (some with great correlation), low commissions and algorithms that help them to efficiently execute their trades. Here is a simple example:

United states treasury bonds and notes and their derivatives are some of the most traded and liquid products in the worlds. Their futures contracts usually have 4 quarterly expiration contracts. Every 3 months everyone who has a position in the front month (usually the most traded and liquid contract), must exit their position or move it in the next contract. This process is called the quarterly roll.

Edge – the advantage of professionals or why we need an edge when trading
Снимка: Личен архив

On the picture we can see the market for a calendar spread – an exchange traded product that represents the difference in price between two futures contracts. The spread allows traders to exit one position in the expiring contract and simultaneously open another in the following. In this example this is the calendar spread between the expiring March 2018 contract in the two-year treasury notes and next contract expiring in June 2018 (3.5 months later). In the grey stripe in the middle are the spread prices. On the left, in the blue stripe are the bids at each price and on the left in the red are the offers at each price. Currently, the best bid is at price 080 and the best offer is at 082. At the bid there are 1,964,945 contracts ready to buy at that price and on the offer, there are 2,457,873 contracts ready to sell. MMs are the ones who have amassed such large orders on both sides of the market. If, for example, a fund manager is long 10 future contracts in the March 2018 contract, and they want to roll their position in the June 18 contract, they can do one of two things – sell the first and buy the latter separately, or they can sell 10 calendar spreads.

On the far-right column we can see just that – 10 spreads trade against 080. From all the people who bid 080 whoever has their order first at that price, or whoever has the largest order will get more of those 10 contracts. This is main reason there are such large orders at the best bid and best offer. The goal of MMs is to buy as many as possible at 080 and sell 082. MMs will “sit” at those prices as long as there are huge orders present for them to “lean” on. Should many of the orders disappear the traders will remove their orders and if they bought a certain amount, they will be able to sell at the same price before it disappears. This is their main edge in this case.

Their second edge is that MMs have large capital at their disposal. The bigger order they put in the market the larger share of the traded contracts will be allocated to them. In the example above, left of the blue tripe shows my orders on both sides of the market – 24000 to buy and sell. The exchange maximum allowed is 25000.

The next advantage professional traders have is a simple, but highly effective algorithm that follows the size on each bid and offer and removes the traders’ order should the size decrease dramatically. The goal is to manage the size a trader buys, or sells, at each price, since the trader doesn’t want to be filled on his entire order, just use its size.

Another edge is that their algorithm is hosted (operates) on a server that is located next door to the exchange. This is called co-location, costs quite a bit, but is worth every penny. This advantage allows everyone who is closer to the exchange server to execute and manage their position better and faster, hence making them more successful.

The above example is the simplest example of market-making. If you can imagine this with 15-20 such products that trade simultaneously on 6 monitors, then you can glimpse in the everyday life of a professional trader. Now multiply this by a 1000 and will gain some perspective of how algorithms of big funds trade today.

Arbitrage

Arbitrage is to buy a product somewhere and sell it somewhere else immediately for a higher price with no (or very little risk). There are many products (stocks, futures contracts, etc.) that trade on multiple exchanges. Others trade over the counter (OTC) – not on a regulated exchange but among banks, funds, and other financial institutions. Sometimes there can be discrepancies in prices, which leads to arbitrage opportunities. In the movies we have seen those arbitrageurs talk on 2 or 3 phones at the same time. Today, all this is done via algorithms and is called high frequency trading (HFT).

The edge of arbitrageurs of the past and today’s HFTs algorithms is the speed they execute their transactions. And if back in the days you needed 2-3 traders per product, i.e. a trading floor with 1000-2000 people, today you need a few algorithms ran by a couple of people. Which is yet another advantage only large funds and banks have.

Statistical arbitrage

This is a strategy that is used in short to medium term trades and consists of multiple trades across multiple instruments that have some similar (or clear dissimilar) movement in prices. This is a long-short strategy (buying certain products, whilst selling short other with great correlation) and is heavily dependent on mathematical models, extensive data bases and once again – fast algorithms. These algos calculate historical correlation between the products and the probability of it holding during certain periods and situations. All this is run by statistical models, working day and night on very powerful servers.

Trading single stocks is no different and there is no free lunch. Many of the modern trading platforms and the new fintech companies like Robinhood and Revolut provide trading without commission. Great, eh? We can mess around trading more than before because we save on commissions. Do we stop for a second and think of the reason this service is offered to us? Don’t the brokers want to make money? Well, they do and they do well. Their biggest income stream is from large funds and HFT firms that buy the data about their customers’ orders and trades. Yes, your every order, every change in the order, every trade is sold in real time. The buyers know before everyone who buys and sells what and at what price. It’s like playing poker and seeing everyone’s cards.

All these are just a few basic examples of professional strategies, but the bottom-line is he same – everyone in the market knows more than us. They are professionals and they do this all day every day and usually spend weekends researching the market and the products. They know every single detail about every product or stock, they know the news before us, they analyze data and execute their trades faster than us, they use algos and statistical models, and have servers co-located next to the exchanges. They have access to our orders and trades and are very well capitalized. So, if you don’t have most of those advantages, don’t even think about being a trader. The truth is – you don’t stand a chance.

HOWEVER, there is good news – we (almost) all have one edge that trumps all the above-mentioned banks, professionals, funds, etc. – TIME. They don’t have time, they must make large amounts of money every day, every month, quarter and year, otherwise there won’t be a bonus. That’s why many of them, however successful in a short period of time, sooner or later lose large amounts of money. For us, though, time is a friend. If we are to save and invest regularly, effectively and long-term we will take advantage of the markets rise and will not fall in the trap of professional traders.

Be prepared!

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