While I know quite a bit about market theory and the “big picture” I’ll admit I don’t know much about the nuts and bolts of how the NYSE, NYMEX, and the like actually work.
In this day and age, why do we still have pits full of traders shouting orders? It seems like we should be way past this by now. As I understand, the NASDAQ is basically electronic, which seems natural.
I’ve worked in a trading environment before (as an economist, not a trader), where we used a lot of different methods to trade commodities. Most seemed pretty efficient, except the big exchange, NYMEX, where placing a trade would ultimately end with some bozo in New York shouting. Any ideas as to why this is still done?
One reason is that there are market makers in the pit. Basically they will give a 2 way price and provide liquidity. They make more spread than the average guy to cover the risk. The liquidity they provide is important.
Second is that the market makers tend to be specialists in a few stocks, or products. Therefore, they are very clued into when there is abnormal volumes and tend to act as a natural “circuit breaker” to slow down the action or alert that there is something out of the ordinary going on. Also the market makers are important to help prevent their customers from getting picked off.
At least the above was true 15 years ago when I was in the biz. Don’t know about now but assume it is the same.
May I ask a slightly high-jackish question? Where do floor traders fit into the hierarchy of finance? Is it part of the career path to a corner office at a big firm, or does it have its own trajectory?
A busy trading floor is an intimidating environment. You not only need to understand the market but must be assertive, aggressive even, if you want to get in on the best trades. This gives the experienced trader a real advantage and they are therefore resistant to a change to electronic trading as it evens out the playing field somewhat.
As a 5 year old might ask, but WHY are the market makers in the pit? Couldn’t they make the market, provide liquidity and be experts at a desk instead of standing in a throng of guys shouting and waving paper around?
It’s still a better place to communication dozens of orders a minute and still be aware of potential problems. If one person is doing it (which is how the NYSE works), he can see all trades at any given moment, make adjustments, match buyers, etc. You certainly can do it electronically (as NASDAQ does), but there’s no major advantage to that, and with one point of contact and one market maker, things can run smoothly.
As a rough explanation, the specialist in the NYSE handles trading for a set group of stocks. If someone wants to buy or sell the stock, they put in an order, which is written down and given to the specialist. He takes these orders and matches them (If someone bids 20 and someone wants to buy at 20, he’ll match buyer to seller) and takes a small portion of the trade (usually a price differential – the buyer pays $20 and the seller gets $19.88, for instance). The specialist also owns the stock he is trading, so if there are buyers but no sellers, he sells his own stock (or buys for his own stock if there are no buyers). He is at risk if there are more sellers than buyers.
The system works nicely, and there’s no real advantage to switching to electronic trading.
A long time ago I worked in the S&P 500 pit at the Merc. The greatest advantage I saw to the open trading system was the traders being able to “read” each other. They watched the boards and listened to the offers but they also watched body language and facial expressions like poker players. Who was nervous, who was hiding something, who looked too eager were all things that could only be seen in person and not off a computer screen. Some of the best traders I knew didn’t even have business or financial degrees but instead had studied psychology or sociology. They could almost read the minds of the other folks in the pit. Scary and very impressive.
I don’t know how those guys handle it day after day. I was only there for a about a year and started chewing up Tums like they were Tic-Tacs. I quit after Black Friday of 1989. My stomach and blood pressure thanked me for it.
A petite, red-headed girl that I went to college with was dead-set on working in a pit. She found a connected alumni to help that happen and she family had that job at the Chicago Commodities Exchange by the age of 24. I sat next to her a common friends wedding a year or so after. She showed me the bruises she got from her job in the past week on her arms and sides. She also told me about bruises she gave other people including large men from her job on an almost daily basis. I forget how much money she said she made but it was well into the six figures. Some people in the pit try to physically hurt any competition in any way they can including physically. They don’t often break out into full-blown fist fights because they have very stressful, busy and frenetic job that pays a lot but the culture sounds bizarre to me as well.
I don’t buy that it’s more efficient, necessarily. It’s just that the knowledge required to program computers to do what they do can’t be had because traders are vicious domain-defenders. I think it’s just a way to avoid transparency. It’s not a free market when only a handful of insiders are calling the shots.
Besides the physical stress there was a lot of drinking and drug use to deal with the pressure. I don’t know how many times I saw guys returning to the pits from the bathrooms with little bits of white powder under their noses. Ah, good times.
Nothing you have ever experienced will prepare you for the absolute carnage you are about to witness. Super Bowl, World Series — they don’t know what pressure is. In this building, it’s either kill or be killed. You make no friends in the pits and you take no prisoners. One minute you’re up half a million in soybeans and the next, boom, your kids don’t go to college and they’ve repossessed your Bentley.
No matter how you program, the computer can’t have the same type of judgment that a human has (especially a human whose own money is at risk). Prices would rise and drop according to pre-programmed rules, which may not apply in the situation. Even NASDAQ has humans involved in the trading process.
Computers might drop a stock precipitously due to a flurry of heavy selling that a human would recognize was a result of some temporary issues that don’t affect the underlying value of the stock or the market as a whole.
The October 1987 stock market crash was caused in part by computers following their programming in response to a situation where human traders would recognize as a temporary blip. Computers still cannot replace human judgment on issues like this.
But most trades are done electronically. NASDAQ is an electronic trading system which trades more shares than the NYSE. Since 1988, the NYSE has had its Small Order Execution System, an electronic trading system for all of its listed stocks. Orders for 1000 shares or fewer are executed on the SOES system. It is mainly large blocks of stocks for institutional investors which make it to the trading floor of the NYSE.
And you essentially have something like the NASDAQ, which still has Market Makers. The just work over computer networks rather than face to face:
“Electronic” does not mean that the order process is entirely automated. Just distributed. Whether or not you could entirely automate trading for a large market, and whether it would be desirable to do so, is another question.
I’m pretty sure that for the majority of orders on both NASDAQ and NYSE, the entire process is entirely automated. Buys and sells are matched electronically intra-day, and reconciled in automated batch processes after the close. Large orders (over 1000 shares) and odd lots are typically the trades which make it to the floor.
The large orders are important, though. Actually, the typical small trade you make through your broker for a heavily traded issue is often filled in house by the broker from their own inventory, which tends to reduce the number of small orders that actually reach the market:
As they note:
The customer likes it, too, because it gets filled fast.
