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What techniques do floor traders use?

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  #1 (permalink)
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I've always wondered what techniques floor traders use to trade in the pits of exchanges without using charts. I've tried to research this but couldn't find any useful information. Most documentaries and such don't really go into the specifics. Could anyone enlighten me on how people trade in the pit or point me in the right direction to material on the web or links to other threads that would explain this process a little bit more clearly? Thank you, I appreciate Big mike and this communities feed back.

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Itchymoku View Post
I've always wondered what techniques floor traders use to trade in the pits of exchanges without using charts. I've tried to research this but couldn't find any useful information. Most documentaries and such don't really go into the specifics. Could anyone enlighten me on how people trade in the pit or point me in the right direction to material on the web or links to other threads that would explain this process a little bit more clearly? Thank you, I appreciate Big mike and this communities feed back.

Floor traders mainly relied on order flow from the buyside, as incoming orders would allow them to take the opposite side of the trade and later match this with another buyside order. The noise level on the floor would tell them how many orders were coming in.

As far as they used any price levels, these were known prior to the start of the floor session, such as the highs and lows of prior day, prior week, prior month and floor pivots.

But ask somebody who really knows, such as @tigertrader.

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Fat Tails View Post
Floor traders mainly relied on order flow from the buyside, as incoming orders would allow them to take the opposite side of the trade and later match this with another buyside order. The noise level on the floor would tell them how many orders were coming in.

As far as they used any price levels, these were known prior to the start of the floor session, such as the highs and lows of prior day, prior week, prior month and floor pivots.

But ask somebody who really knows, such as @tigertrader.

anyone else. @Fat Tails is exactly correct.

On the trading floor...at least in my time, prior high, low, open, close, floor trader pivots. His comments on the noise level as a audible cue is especially interesting as you don't hear things like that very often from guys that are not experienced on the floor.

From a "floor" perspective what most of us do here is short term position trading. The "edge" on the floor (true trading) came from two basic areas. Order flow AND your relationship with the floor broker was primary. Second was how you priced your markets. Guys did use visual and auditory clues. I imagine HFT and increase in technology have changed that a bit now.

Flow and relationship are pretty much self explanatory. My floor was CBOE. Keep in mind that equity spreads where 1/4 or 3/8 wide on the underlier and at least 1/8 on the option. So say you bot puts and stock on your bid, you could offer calls down an eighth. This would be called "legging a conversion" and in this case is done for 1/2 a point in a "riskless" position neutral trade.

So the pricing method was the real edge given there was still a tangible spread. Conversion, reversal, box, roll was how the pricing model would go. In the above example if paper came in to sell puts, you would price based on where you could buy stock and sell calls (the conversion) relative to strike price, interest and execution costs.

This describes risk arbitrage and generally does not require any indicator to be really good at it. Of course guys had huge positions on and sometimes would tend to "lean based on that and their bias. But most of the time the entire crowd was in pretty much the same position. We could change our implied volatility or tighten/loosen the spread of our products to influence order flow.

I should say that conversion, reversal, box, roll, was how I priced. Some guys where spreaders, some guys just sold premium, etc. Could give examples on these if anyone cares.

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Yes - would love to hear any and all details you care to share... Interesting stuff.

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wldman View Post
anyone else. @Fat Tails is exactly correct.

On the trading floor...at least in my time, prior high, low, open, close, floor trader pivots. His comments on the noise level as a audible cue is especially interesting as you don't hear things like that very often from guys that are not experienced on the floor.

From a "floor" perspective what most of us do here is short term position trading. The "edge" on the floor (true trading) came from two basic areas. Order flow AND your relationship with the floor broker was primary. Second was how you priced your markets. Guys did use visual and auditory clues. I imagine HFT and increase in technology have changed that a bit now.

Flow and relationship are pretty much self explanatory. My floor was CBOE. Keep in mind that equity spreads where 1/4 or 3/8 wide on the underlier and at least 1/8 on the option. So say you bot puts and stock on your bid, you could offer calls down an eighth. This would be called "legging a conversion" and in this case is done for 1/2 a point in a "riskless" position neutral trade.

So the pricing method was the real edge given there was still a tangible spread. Conversion, reversal, box, roll was how the pricing model would go. In the above example if paper came in to sell puts, you would price based on where you could buy stock and sell calls (the conversion) relative to strike price, interest and execution costs.

This describes risk arbitrage and generally does not require any indicator to be really good at it. Of course guys had huge positions on and sometimes would tend to "lean based on that and their bias. But most of the time the entire crowd was in pretty much the same position. We could change our implied volatility or tighten/loosen the spread of our products to influence order flow.

I should say that conversion, reversal, box, roll, was how I priced. Some guys where spreaders, some guys just sold premium, etc. Could give examples on these if anyone cares.

I have never heard of those strategies, but I am interested to learn more. This is what I have found at Welcome to Discover Options .....


Conversion:

The price of the put and call options across the same strike prices can not get very far out of line from the fair value dictated by the underlying price. As long as the risk and reward is the same, a synthetic call should cost the same as an actual call option. If it is not, then an arbitrage opportunity exists. You can buy the cheap one and sell the expensive one for a risk-free return. This is what the conversion strategy does. A conversion involves:

• Buying 100 shares of the underlying stock
• Buying a put option; and
• Selling a call option (at the same strike price as the put).

The long stock (in the same amount specified in the options contract, 100 shares in the case of most stock options) plus the long put creates a long synthetic call. This is then offset by the actual short call option. This is a no-risk position. The potential return is simply based on the traded prices of all components.

Another way to look at the conversion strategy is to group the option positions together and compare them to the underlying position. Combining the long put and short call create a synthetic short position in the underlying. The put makes money when the market drops and the call loses money when the market rises, so having the two option positions is just like being short the underlying. The conversion is completed, then, by buying the underlying, offsetting the synthetic short.

No matter how you look at it, you can see how puts, calls and the underlying asset are closely related. One value cannot move too far away from the other. The Graphic Analysis for most arbitrage strategies looks quite boring: A single horizontal line.



In this case, the calls and puts for XYZ Corporation are fairly valued. There is no reason to try this one at home, because if you put this trade on, in 29 days you would just be guaranteed to lose $16 no matter what the price of the underlying stock. However, if you found a case where the line was substantially above zero than the horizontal line would become quite exciting. If you could then actually execute the trade at those prices, it would mean you found a mispriced conversion, meaning a guaranteed profit with no risk!


The Reversal Strategy

The reversal strategy is just the opposite of the conversion. That is, you sell the underlying short and place a synthetic long position. The actual transactions needed would be:

• Short 100 shares of the underlying stock
• Buy a call option; and
• Sell a put option (at the same strike price as the call).

Looking back at the table of synthetic relationships, you can see that it can again be grouped a different way. The short underlying position plus the long call is a synthetic long put option, which is then offset by the actual short put option.

Again, there is no risk in this position. The only reason to do it is if you can buy the synthetic put for less than the bid price of the put you need to short. This is just another example of the "buy low, sell high" theme that runs throughout the investing world, except that no time lapse is involved. You get to buy low and sell high at the same time.

It is easy to get confused with these strategies, but remember the point of this section. It is to show how the calls, puts and underlying are related. The price of any one cannot move very far without the others adjusting as well.


Put-Call Parity and Box Spreads

In addition to their relationship with the underlying asset, the price of each option is also related to the price of all the other options. The value of the puts and calls are related by means of an important theory in options pricing called Put/Call Parity. This theory says that the value of a call option implies a certain fair value for the corresponding put, and visa versa.

Naturally, there are arbitrage strategies that are designed to profit if these relationships get out of line as well. I won't go into the theory of Put/Call Parity here, since there are already other articles here on DiscoverOptions.com that go into this subject in detail.

You may have already guessed that the previously discussed conversions and reversals are two arbitrage strategies that could be used to take advantage of any mispricing in the relationship between puts and calls. But you can also do both of them! When you do a reversal at one strike price and a conversion at another (all options in the same expiration month), the long and short positions in the underlying cancel out, and you are left with what is called a Box, an arbitrage strategy that uses four different options.

It is probably easiest to think of a box as doing both a bull spread and a bear spread. One spread is established using put options, and the other is established using call options. The spreads may both be debit spreads (a bull call spread vs. a bear put bear spread) or both credit spreads (a bear call spread vs. a bull put spread). Below is an example of one using the options in our hypothetical XYZ Corporation again.



As you can see, the options are fairly valued and the only result of placing this particular trade would be to make you poorer by $140 (and your broker a little richer). The risk graph is simply a horizontal line, just as all truly risk-free pure arbitrage trades would be.


Inter-Month Relationships and Jelly Rolls

The previous arbitrage strategies all used options within the same expiration month, and we have seen how the underlying and these options are related in one way or another. What about options from one expiration month to the next? Are there relationships between these as well? Yes, there are.

Under normal circumstances, the implied volatility of the options in the farther-out months is a little higher than the front month. When that relationship is backwards, it may seem like a great trading opportunity. When traders see this happen they tend to think about placing calendar spreads that involve selling front month options and buying the farther-out options. The idea is to sell higher implied volatility and buy lower implied volatility, and then make money when the volatilities reverse themselves.

But there can be a problem with taking this route. Calendar spreads are typically market-neutral strategies that make money only if the stock stays in a narrow trading range. But keep in mind that implied volatility is the market's expectation of the magnitude of future stock price changes, and implied volatility that is higher in the front month than the back months is usually telling you something.

When you see implied volatility higher in the front month, there is almost always a reason for it. For example, it could be an upcoming earnings announcement, uncertainty regarding a particular sector, or an upcoming news item such as an FDA announcement. In those situations, the stock price could move up or down a great deal, depending on how the marketplace interprets the news or announcement.

When a stock moves around a lot, market neutral trades are not necessarily going to be profitable, even if you sold high implied volatility and bought low implied volatility. So when you see situations where the front month volatility is much higher than a farther out month, do some research before you enter any trade. You will probably find the reason why others are predicting wide short-term swings in the price of the stock.

With that word of warning out of the way, let's show how the options of different months are related using an arbitrage strategy call a "jelly roll", sometimes simply called a roll. To do this, we will again start with the conversion and reversal strategies. Consider the following reversal using our hypothetical XYZ Corporation:

Short 100 shares of the underlying stock at $75 a share.
Long the August $75.00 call option
Short the August $75.00 put option; and

Now, a conversion:
Long 100 shares of the underlying stock at $75 a share.
Short the December $75.00 call option
Long the December$75.00 put option; and

If we place both positions simultaneously, the two underlying positions cancel out, leaving you with the following position:

August options December options
Long $75 call Short $75 call
Short $75 put Long $75 put

This is a jelly roll. It may be easier for you to think about this in the synthetic sense. You have a synthetic long stock position in the August options and a synthetic short stock position in the December options. You are just spreading one month versus the other.

If you are dealing with futures options, where these option months would be based on different futures month, then you are essentially just trading one month's value versus another. But when you are looking at a stock, this opens up some interesting issues.

Think about what this position actually is. Once you reach the August expiration, you will be left with a long position in the stock. Why? If the stock price moves up, the call option will be in-the-money and you would exercise it. If the stock price falls, the put will be in-the-money and you will be assigned. Either way, you will be long the stock.

The December position is just the opposite—you would be short the stock after expiration. Once you reach this date, the short position would, of course, cancel out the long position. In a way you could say the jelly roll is a position where you arrange to be long the underlying at some point in the future and then hold it for a short period only.

Now we need to think about how the position should be priced. It all has to do with carrying costs and dividends. Carrying costs refers to the cost of holding the stock for the four-month period from August to December. With the current risk-free interest rate at about 1.75% and the stock at $75, the cost of carry for four months is:

$75.00 x 3/12 x 1.75% = 2.625¢

This is what the jelly roll should be priced at without dividends. If it is less there would be an arbitrage opportunity. In fact, placing this exact trade would cost 7¢ or a net debit of $70, so no arbitrage opportunity currently exists in this situation.

You can see how a change in just one of the component options would provide the smart traders out there with an opportunity. As they began to take advantage of it, they would drive prices back in line. So any deviation from "fair value" would not last very long. Keep in mind that the reason we are looking at this strategy is not for you to turn around and trade it. It is to simply understand how the option prices are related.


@wldman: I would appreciate, if you were willing to comment the different approaches to explain how they played out, and whether they really made money.

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@fattails

Those strats ( risk reversals etc ) are not something that a retail trader can do and make money doing.

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I've always wanted to learn options, but have my hands full in technical trading.

I'm trying to understand the different strategies (and as I understand it, there are dozens), but I imagine it's similar to sports betting where you try to find a disparity between 2 different bookies and create a risk-free or nearly risk free transaction.

If you can bet Washington -3.5 and turn around and Bet Dallas + 5.5 with another bookie, then if Washington wins by 3 or less, you win one, lose the other, pay the vig on both. If Washington wins by 6 or more same thing.

But if Washington wins by 4 or 5, you win both bets, so essentially, you're risking like 10:1 odds.

Professional bettors try to identify lines they know that start out extreme and they know will move. They jump in at the extreme and then hedge the other way when it moves. (similar to fat tails horizontal line example).

I know it's off topic, but the concept is similar....obviously with options, it's a little more head centric and tougher to wrap your brain around.

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traderwerks View Post
@fattails

Those strats ( risk reversals etc ) are not something that a retail trader can do and make money doing.

if anyone can make money that way anymore. The spreads are pennies and expenses are too high. There is just no edge most of the time even for the floor guy.

My DPM (direct primary market maker) was a huge firm. They could tone down our displayed implied volatility to make our CBOE markets essentially the NBBO because their execution expenses where zero, their clearing expenses where zero and their interest rates did not matter because it was one division of the company paying the other for cost to carry.

The rest of the crowd was firm traders from other companies and locals like me. The locals could not compete because we pay higher and get lower interest and our trade related expenses where higher. Firm traders could break even at the DPM's markets. So to get market share and payment for order flow as well as commission from the clients upstairs the DPM would execute break even on the floor.

In the example above, a conversion, I'd buy puts (paper) on our bid, buy stock on NBBO and cell calls away on our offer to lose a dime....screw that. BUT when paper came in that was against the crowds position...and that happened often, the DPM expected you to honer their markets for your typical size. CRAZY!!

Reminds me of a great story:

Our group and another group (the former DPM) merged. We needed a guy in that crowd and that was going to be me if I liked it or not...lol. It is brutal even as an experienced guy to move into a new crowd...brutal. So I show up in the new crowd and it looks pretty thin, like 8-10 guys. Nobody is giving it to me real bad, mostly because of my size (physical) and reputation (physical). Then, my third Monday in the crowd, there are like 16 guys in the pit. Of course Im standing in somebody else's "spot" and the shit kid of starts. Two guys where on vacation and 4 guys had been at the olympic games in Salt Lake.

I took a bunch of hell then finally made my "speech". The guys backed off a bit and gave me the business asking me where my markets where and asking me my size. They where CHOKING on premium especially in WCOM. WCOM had been a NASDAQ leader trading in the 50's and 60's. The shit had started to hit the fan there but the stock was still trading. The guys in the crowd asked for my market in WCOM out month puts, the $2.50's and the $5.00's. Knowing they where long and that that days news seemed positive for WCOM, the guys wanted me to buy some premium. I gave my market and everyone yells "SOLD". They where pissed that I would not buy my typical size from each one of them individually. I bot a couple hundred $2.50's and maybe 100 $5.00's just to "fit in".

Within a couple days the news broke on WCOM and the stock was well under the bid from where I purchased hundreds of puts. I was still naked on most of that position as the maximum possible loss was well with in the "cost" of being one of the guys. The crowd did not know that in my NASDAQ days I made a market in WCOM, and that I understood it's business, its market and especially it's CEO , better than almost anyone. Remember equity market making was more direction sensitive that options.

The Chicago Tribune was in the crowd taking pictures...I was on the front page. The caption implied that I was hurt by WCOM woes. Nothing could have been further from the truth. My concern was that the crowd was hurt really bad and that my purchase of their premium at fire sale added to it....I just wanted to fit in. If I can find that photo I'll scan it and use it for my avtar.

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I see your question and I will love responding to you for a change. That which you copied to the thread is just about the perfect "textbook" for the pricing method that I was referring to. Let me read that again and see if I can tell what input you might enjoy from me. DB

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