Davis Edwards on Trading

 

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Introduction to Trading

Trading is the business of buying and selling securities or commodities with the goal of earning a profit. The term trading typically refers to a business that holds an inventory over a short time horizon (less than a year) while the term investing refers to a business that holds positions over a long time horizon (more than a year). While there are some cases where the distinction between the two terms is important, the same basic terminology applies to both and the terms are largely interchangeable in many situations.

Portions of this discussion were adapted from the book, “Risk Management in Trading” by Davis W. Edwards, published by J. Wiley 2014.


What is a trade?

What is a trading position?

What is a trading desk?

Where can trading occur?

What types of decisions can traders make?

 


What is a trade?

A trade is a special type of transaction purchasing some type of standardized asset for resale at a later point in time. This makes a trade different from many other transactions. For example, buying stock in a company for resale in the near future is an example of a trade. An important feature is that if the stock had to be resold immediately after it was purchased, there would likely be other willing buyers willing to pay the trader a price similar to what was initially paid. In contrast, buying a cheeseburger is probably not a trade since the cheeseburger probably could not be resold, Even if it could be resold, it would probably lose substantial value immediately.

Another key element that allows assets (or liabilities) to be traded is the ability to substitute identical products for one another. For example, it is very difficult to set up trading based on unique works of art. The negotiation between buyer and seller is too specific, and the worth of the piece too subjective, for prices to be fully generalized. However, it is possible to trade interchangeable products and use those transactions to determine a fair price. The ability to substitute equivalent products is called fungibility. For example, shares of common stock in a company are interchangeable. It is possible to buy shares of the same stock from two different people and the shares will be identical in all respects.

Like any type of transaction, trading requires two parties - typically a buyer and a seller. From the perspective of a trader (or a firm employing a trader), the other party in the transaction is called the counterparty. Typically, the price at which the asset (or liability) is transferred is based on voluntary negation between the two parties.

There are three major transaction types:

·         Buy. Buying is associated with paying money to acquire an asset.

·         Sell. Selling is associated with receiving money as compensation for transferring an asset to the buyer.

·         Short Sell. Short selling is the practice of agreeing to sell something that is not currently owned but is expected to be owned in the future.

In some cases, alternative terminology is used. For example, the terms “buy” and “sell” do not really describe what happens when two assets are being exchanged for each other. In those cases, other descriptive terms may be used instead of “buy” or “buyer” and “sell” or “seller”.

Because it involves both a buyer and a seller, trading is impossible in isolation. Trading is a group activity. Some markets, like exchanges, obscure the buyer/seller relationship. However, even in those markets, buyers and sellers are matched up and work together to create prices. Markets where buyers and seller can easily find one another are called liquid markets. Markets where it is difficult for a buyer and a seller to meet are called illiquid markets. Regardless how much an asset might be worth to the right buyer, unless that buyer is willing to buy it right then, there is no way to convert an asset into cash. This is called liquidity risk.

In summary, trading requires:

                     A buyer or a seller willing to take the other side of the transaction

                     The ability to both buy and resell quickly without a substantial loss of value. A substantial loss of value might be 10%.

                     The ability to define standard products which can be interchanged with one another (these are called fungible products)


What is a trading position?

One type of trading position is a job at a trading company. However, the term position also means the net effect or one or more transactions. For example, if a trader executes two trades, each purchasing 300 metric tonnes of aluminum, the result is a 600 metric tonne position.

Traders use the term long and short to describe positions. A long position becomes move valuable when prices go up. A short position becomes move valuable when prices go down. For trades that involve a transfer of wealth (for example, a derivatives transaction), the traders will end up with opposite positions - one trader will benefit if prices go up (that trade has a long position) and the other will benefit if prices go down (a short position). In the example of a trader that owns 600 metric tonnes of Aluminum, this is a long position since the trader benefits when the price of aluminum rises.

The reason that traders use long and short is because the terms buy and sell can get confusing. They get confusing because contracts can be traded in the same way as assets. For example, it is possible to buy a contract that obligates the owner of the contract to sell an asset. The transaction that led to the position (buying a contract) is less important than the end result (the trader now has an obligation to sell an asset). To reduce confusion, traders use the terms long and short to describe positions.

Traders use terminology to describe positions:

                     A “long position” profits when the price of the asset increases and loses money when prices drop.

                     A “short position” profits when the price of the asset declines and loses money when prices rise.

                     A “flat position” does not either gain or lose money when prices change.

These terms can refer to both contracts and the net effect of the contract. For example, when risk management or the head of a trading group examines trading positions, the terms long and short typically refer to the underlying asset exposure rather than the individual contracts. This allows the exposure from multiple contracts to be combined together (netted) and reported as a single number. In this example, perhaps a trader has purchased a put contract on Aluminum (a contract that allows him to sell Aluminum at a fixed price). The trader has a long position in the put contract (he benefits if the put contract increases in value) and a short position in Aluminum (the trader benefits when Aluminum prices decline).


What is a trading desk?

Individual investors will have to handle all aspects of trading by themselves. However, many trading organizations (like hedge funds) are large enough that they can support specialists in every aspect of the trading process. In these groups, there will a wide variety of people involved in making trades and managing the risk of those trades. Commonly these groups are divided into a couple of major categories: Front office, support and control groups, and the back office. (See Table 1.1 - Roles on a Trading Desk)

Table 1 - Roles on a Trading Desk

Front Office

Support & Control

Back Office

1.       Sales & Origination

2.       Deal Structuring

3.       Scheduling

4.       Trading

5.       Middle Office

6.       Risk Management

7.       Financial Control

8.       Reconciliation (Clearing)

9.       Margining

10.   Documentation

 

In a trading organization, the front office consists of various teams whose goal is to make trades on behalf of the organization. The front office is also referred to as the “commercial” group. This team is responsible for identifying trading opportunities, making trades, and managing any ongoing investments.

1.       Sales & Origination. The sales team is responsible for identifying potential trading partners and clients who need trading assistance. In cases where clients are likely to have complex needs the sales team may be called the origination team.

2.       Deal Structuring. In many cases, determining a price for an asset requires substantial mathematical analysis. The deal structuring team on a trading desk will be responsible for calculating fair prices and valuing complex (structured) transactions. These are typically quantitative, math-heavy groups found in front-offices that trade derivatives or other complex products.

3.       Scheduling. Trading physical assets like commodities often involves a substantial amount of operational complexity. When trading desks trade products that are complicated to deliver (or accept delivery on), a dedicated team focuses on making sure that process goes smoothly. Scheduling teams need to understand minute details of the markets for which they are responsible.

4.       Trading. The trading desk is responsible for executing transactions and the market-focused follow up of monitoring and managing existing positions. In some firms, there are a variety of trading desks specializing in different areas. Different trading teams will usually have descriptive names like the foreign exchange trading or the natural gas trading. If the trading is done on behalf of the firm, this may be called proprietary trading to distinguish the trading desk from one supporting clients.

The trading desk is supported by several teams that provide operational controls over trading activity. Even though these groups generally sit close to the trading desk, they typically report to a different management team - one that is not directly in the trading chain of command. These groups are the support and control teams.

5.       Middle Office. The middle-office is responsible for ensuring the trading desk works smoothly. The middle office ensures that trades are properly entered into tracking systems, that existing positions are valued on a daily basis, and that all of the paperwork is completed properly.

6.       Risk Management. Risk managers assigned to trading desks ensure that traders are not taking on too much risk and keep management informed of ongoing risks associated with the current trading positions.

7.       Financial Control. The financial control team is responsible for accounting and profit and loss (P&L) reporting. The trades done by the trading desk ultimately need to be reflected into the firm’s books and records and reported to the limited partners (shareholders if it is a public corporation) and the government. The Financial Control team is responsible for putting together those reports.

The “Back Office” provides post trade processing, settlement, and clearing functions to the trading desk. These functions are commonly performed in a location that is remote from the trading desk.

8.       Reconciliation (Clearing). The reconciliation team ensures that the counterparty’s back office agrees on the terms of every trade. If the two parties to the trade can’t mutually agree on the terms, this team might need to pull phone records (trader’s phone lines are typically recorded), instant messages, or emails where the traders agreed to the terms of the trade.

9.       Margining. Trading desks often require trading partners to post collateral when the trading partner owes them a large amount of money. The Margin group is responsible for posting and receiving margin calls since trading partners can ask for their own collateral.

10.   Documentation. The documentation team is responsible for finalizing all the paperwork necessary for trading. Just like the paperwork on any other legal agreement, a substantial amount of work goes into ensuring paperwork is correct for trades.


Where can trading occur?

Trades can occur in a variety of venues. While this can be as simple as finding a trading partner and signing a contract, the customized nature of many contracts prevent them from being traded (transferred to another trader for a cash payment). As a result, it is common for traders to use resources that can help them find trading partners and sign standardized trading contracts. (See Table 2 - Types of Trading Venues)

Table 2 - Types of Trading Venues

1. Bilateral

2. Broker

3. Dealer

4. Exchange

Traders directly find one another.

Traders are introduced to each other through use of a broker.

Trader transacts directly with a dealer

Traders are matched up on an exchange. The exchange simultaneously transacts with both traders.

 

1.                   Bilateral Trading. The trader is responsible for finding a trading partner and signing a contract directly with that partner. Commodity markets where a limited number of producers and consumers interact regularly are often bilateral markets.

2.                   Broker. A broker introduces customers to one another for bilateral trading. In some cases, the broker has the ability to trade on the behalf of the customer. Calling a broker is a common way for traders with limited trading connections to get access to trading markets. Brokers typically get paid a commission for arranging trades.

3.                   Dealer. A dealer executes customer trades against the dealer’s own account. In other words, the dealer is the counterparty for a trade. In many cases, the dealer is a broker/dealer, with the capability of both a broker and a dealer. Like the broker market, traders with limited trading connections often use broker/dealers to get access to trading markets. Dealers will make a profit by offering slightly different prices to buyers and sellers - a bid price that indicates where they are willing to buy and an ask price where they are willing to sell.

4.                   Exchange. An exchange is a centralized location for trading standardized products. It is necessary to be a member of an exchange to trade on it. The exchange interposes itself between buyers and sellers and requires its members to post a refundable good faith deposit, called margin, when they transact. This margin payment will be held as collateral to ensure buyers and sellers meet their trading obligations. If traders are not members of an exchange, the can have a broker/dealer who is a member of the exchange transaction on their behalf.


What types of decisions can traders make?


What? Where? When? How?

In addition to determining what to trade, traders have to determine how and when to accomplish a transaction and pass those instructions to other people. With a bilateral contract (like a forward), terms can be individually negotiated. However, in most other circumstances, traders will use standardized language to describe this information. First, the trader will need to describe how they want the order executed. Then, they will need to determine when they want to do a trade.

Market Orders

In many cases, traders want a fast execution at the prevailing market price. These are called market orders. Market orders are executed by the broker or exchange as soon as possible. These trades should receive the best price available at the time of execution. A market order specifies only the name of the security and the action to be taken (either buy or sell). For example, “Buy 1000 shares of IBM common stock at Market” will instruct a broker to purchase 1000 shares of IBM at the prevailing market price as soon as possible.

                     Market orders are the most common type of order.

                     Market orders are executed as soon as possible

Limit Orders (Limit Buy, Limit Sell)

In other cases, traders might want to accept a trade only under certain conditions. In these cases, traders can use a limit order to specify the price at which a customer is willing to transact. For example, a buy limit order will specify the highest price that the trader is willing to pay. A sell limit order will specify the lowest price that a trader is willing to accept. For example, “Buy 1000 shares of IBM common stock, Limit $50/share” will instruct a broker to purchase 1000 shares of IBM stock if the price drops below $50/share.

                     Limit orders do not guarantee an execution

                     If they are not executed, limit orders will typically remain active for the remainder of the trading day. The order will be canceled at the end of the day if not executed. If a trader doesn’t want this behavior, they will have to specify additional execution instructions.

                     Limit orders have a time priority – the first trader to place a limit order at a specific price receives the first execution.

When made visible to the market, limit orders lead to the concept of bid and ask prices. A bid price is the highest price that anyone using a limit order is willing to pay for an asset. An ask price is the lowest price is the lowest price anyone using a limit order will accept for an asset.

                     A bid price is the price at which a trader is willing to buy an asset while using a limit order.

                     An ask price (also called an offer price) is the price at which a trader is willing to sell an asset while using a limit order.

Stop Orders (Stop Buy, Stop Sell)

Traders can submit orders that are initially inactive but become active under specific conditions. One type of activated order is a stop order. Stop orders convert into market orders if the market reaches or goes through a certain price level (the stop price). Buy Stop orders are placed above the current market price and become market buy orders if the price reaches the stop price. Sell Stop orders are placed below the current market price and will become market orders if the price reaches the stop price.

                     Stop orders are most commonly used to limit losses to existing positions from large price moves. This is called a stop-loss. For example, a trader might enter a stop-loss order to liquidate a stock investment if prices drop more than 10%.

                     Stop orders can also be used to enter positions if the market hits a certain level. For example, a trader following a technical analysis strategy may wish to trigger a buy order if the market rises above some resistance level.

Stop Limit Orders

If traders need to give more complex instructions, they can create stop limit orders. Stop limit orders combine features of both stop and limit orders. These will work similar to stop orders, except that a limit order will be created rather than a market order.

Timing of Trading

Another factor in submitting futures transactions is how long the order will stay active before it is executed or cancelled. These instructions primary apply to limit orders since market orders are filled immediately. By default, limit orders are good only on the day which they were submitted and the instructions go into effect when the broker or exchange receives the order. However, other instructions are possible.

                     Day orders. The most common lifespan for a limit order is the remainder of the trading day on which it was submitted. This is typically the default lifespan for orders if no special instructions are provided.

                     Good till Canceled (GTC). Traders can submit orders that are good indefinitely (unless they are canceled). GTC orders, also called open orders, remain in effect until they are canceled.

                     Fill-or-Kill (FOK). In some cases, traders want an immediate execution but wants to place a limit the maximum price they pay (or minimum price they receive) for an execution. Fill or Kill orders are immediately executed to the extent possible and then canceled. In many cases, these orders will not be fully executed. These orders are typically used in conjunction with a limit price.

                     At-Open, At-Close. Most orders become active as soon as they are submitted. However, sometimes traders want to match the opening or closing price rather than get an immediate execution. For example, a derivative contract might specify that the underlying is priced at the market close price on the expiration date. To limit the risk associated with a mismatch between the contract exposure and the trading price, the trader might wish to transact as close to the close as possible. Open and Close orders are typically executed on a best-effort basis. It is also common for exchanges to require these orders to be submitted early. For example, an exchange might stop accepting market-on-close orders 15 minutes prior to the close. If a large number of orders might come in right at the open or closing time, the market on open/close orders might only guaranteed to be executed at a price within the range of prices being traded during the open or close - not necessarily at the official open or close price.