From the September 01, 2009 issue of Futures Magazine • Subscribe!

Lessons from pit-traded markets

FROM PIT TO SCREEN

The amalgamation of these two strategies, coexisting for the benefit of the marketplace, is a logical response to the questions asked earlier regarding the future of instinctual traders. Simultaneously running your program and keeping an open mind about outside influences will lead to success. In response to the question regarding the benefit of the marketplace and the huge growth in screen-based trading over open outcry, consider the pit-to-screen argument.

Program-based trading exists mainly on screen-based platforms and these orders are executed electronically. Electronic trades can be automatically inserted into a program and offer a seamless entrance to the program, thereby updating it in nanoseconds. Perhaps it may be more cost effective for these programs to use open outcry pit trading.

Often, a quantitative program will have orders to sell based on certain levels and parameters. These programs may generate an excessive amount of orders resulting in excessive commissions. This may benefit the clearinghouse, but it costs the trader.

If the trade is executed through the open-outcry system, the result can be a more competitive price, with a better average. The reason for this is the screen depth, expressed by quantity bid and offered at each price. This depth is thinner and, ironically, less transparent than the price in the pit. The other side of a pit trade is done with a local trader (market maker) who may absorb the trade more efficiently than the screen.

For example, consider the need to sell 200 March soybean meal futures at the market. When this order is executed electronically on the screen, as a market order, the possibility of the price moving by more than $1 (10 ticks) as a result of the execution is to be expected. This same order executed in the pit might only move the price by 50¢ (five ticks). The reason for this is the human element involved on the other side of the transaction.

A soybean meal pit trader will not necessarily offset this trade by automatically hedging within the same contract. A local trader on the other side of this transaction could easily convert this trade by selling a different delivery month other than March, or even sell soybeans, soybean oil or corn. It is also possible that the opposing local will hold the trade because he or she sees the Dow rallying.

Furthermore, the absorption of the trade is now in human hands and your execution has not just triggered every auto spreader and trading program that is running in that contract. A cross-market transparency had been used and the result is a better fill for the trader. The auto-spreader function is important in understanding the dynamics of the trade execution.

An auto spreader is a program that automatically offsets a trade in one contract by doing the opposite in another contract. These can be programmed several different ways and often are used by local traders attempting to leg calendar spreads. Assuming you sold 200 March soybean meal contracts on the electronic platform, the opposing players on this trade, the buyers, could potentially have an auto spreader set up to sell the May soybean meal contract when a March contract is bought. This trade would put that trader into a March/May soybean meal spread at a price possibly greater than that available to the marketplace as an outright spread.

OUTSIDE INFLUENCE

The premise is that an action in one market can affect other markets. This action can be better absorbed by executing trades through open-outcry methods, using human beings. Of course, when a human being is involved, there is room for human error, but that too is an exploitable edge. Contrarily, this human interaction may be able to make a decision that a computer system cannot conceptualize.

Here is a hypothetical situation. Suppose you want to execute a sell stop order in soybean oil. You could place your order on the electronic platform and have the stop triggered immediately when the price level is breached, or you can place your stop order with a human in the pit and let a person decide, based on his or her feelings. This broker may see your level trading but know that the Dow has been lending support and that soybeans just rallied a few cents. The broker may lay off filling the stop based on this outside market information and save you stopping out of a long position with which you originally felt confident and comfortable. Regardless of whether the market continues to trade lower or bounces back, you added in a human factor that could potentially save you money.

Confidence and comfort combined with discipline and intuition will be the key to surviving as a trader. To survive, the human trader must become like a hybrid car, by using a little old-time muscle and a lot of new technology. We must become technology gurus but not forget the intuition that lies in all of us. As social beings that enjoy interaction with others, it might help us to know that there may be someone with knowledge and experience on our team. It is imperative as traders that we continue to adapt to our surroundings and evolve with the rest of the trading world. This can be accomplished by keeping an open mind about outside markets and having the ability to combine several different strategies. Trading is a human activity that employs computers as a tool to help us with our work. A shovel doesn’t do the digging, the person holding it does. If human traders combine the pit benefits with the screen, we will stay in position to keep digging.

Brendan McGlone is a Chicago Board of Trade trader.

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