Blockchain Is Not Kleenex, Cryptocurrencies As Options & The FOMO Index

As a relative cryptocurrency n00b, I have been putting in work on the Twitters following the launch of Bitcoin futures to try to understand the relative merits (and therefore the relative valuations) of Bitcoin, the important but second-tier Ripple, Litecoin and Ether, and the swarming hordes of Alt-coins being created and ICO-ed by seemingly every sketchy nineteen year old with an fsociety hoodie, laptop and free WiFi at Starbucks. Three observations on this nascent market: 1) There is a difference between coin and technology, 2) Crypto market positions can have option-like risk/reward characteristics, and 3) My newly-created FOMO Index.

1) The tradable instrument is one thing, the technology that allows it to exist is another, probably much more significant thing. Bitcoin is a pretty cool tool to punt around on with your spare cash (which can apparently run to a half-billion or so, if you happen to be a Winklevoss or Silicon Valley VC), but one more store of value or virtual casino chip is not nearly as interesting as a secure means of exchanging payment information that could eventually revolutionize virtually every global industry. If, and this a tremendously big if, they can find a way to somehow scale it in such a way that it does not consume a horrifying amount of energy and get the transaction time down to where large users (think banks, exchanges, and according to some commercials, producers of tomatoes) can accommodate their billions of records a day. 

This is the real battle. Who can deploy a secure technology that can scale, not who’s newly-hatched PwnCoin (Is that a real thing yet? It must be.[1]) happens to have doubled/halved on a given day. People, myself included, sling around the term “blockchain” the way we do “Kleenex”, as a brand name that has somehow become default designator for a whole range of similar, but not equivalent, products. As the crypto space continues to evolve, it is very probable that it will converge on the technology that finds the sweet spot on the Venn diagram between security, speed, and affordability. That one, the VHS solution, will Betamax every other technology in rapid fashion (look it up on your smart watch, Mr. fsociety) regardless of their relative technical merits.

2) It seems like every time a Very Rich Person shows up on the financial news to announce a freshly accumulated gigantic cryptocurrency stake, they are met with a fusillade of side-eye rolling and snarky Tulip Bulb jokes by the anchors and pre-arranged Opposing View panelists. I think there is a fundamental misunderstanding of how (some) professional traders and portfolio managers employ high-risk, ultra-high-return instruments: they think of them as long option positions. Obviously, a position in either futures or underlying asset does not have the same non-linear Greek risk characteristics as a derivative security, but many Cryptocurrencies do have similar extremely skewed return properties. Traders frequently employ option strategies as risk-limited leveraged long positions, where they know at the inception of the exposure the maximum of what they can lose and expect that, if things play out as they intend, that they can possibly earn a multiple of that amount. Nobody buys 1,000,000 shares of Microsoft and says “I am comfortable if this goes to zero”, because there is a vanishingly small chance that MSFT goes up 10x-20x during the course of the year to justify risking the entirety of the exposure. Many cryprotcurrencies have done this, and may continue to do so in the future, allowing a trader to plausibly assert that buying and HODL-ing is a productive strategy.

Consider the aforementioned (and as far as I know) fictional PwnCoin. If it were currently priced at $1.00 and a crypto-trader realistically thinks it can go up $15.00 in value during the course of the year, they don’t need particularly good odds of that happening to justify the trade. Traders calculate and obsess about the probability-adjusted risk-reward ratio of the exposures they are contemplating. If the trader thinks it is a 50/50 probability that the PwnCoin finishes the year at $0.00 or $16.00, then the net present value of that bet is +$7.00, yielding a fantastic 7-to-1 risk/reward ratio (with the reward expressed first, then the risk, as is convention). A 25% chance of favorable outcome yields a 3-to-1 ratio. Most traders will seriously consider any trade with a better than 3-to-1 ratio, particularly when the downside is fixed and known pre-trade. Again, this is assuming that the trader is willing to lose 100% of the value of their initial position. Any sort of risk mitigation strategy designed to preserve capital through a stop-loss will skew the risk-reward ratios higher and require a lower probability of success to justify the trade. 

3) Introducing The FOMO Index. As a way of contextualizing the incredibly rapid price appreciation potential of cryptocurencies, I decided to calculate the change in value of a basket composed of $1000 initial positions in Bitcoin, Etherium, and Litecoin starting on Thanksgiving Day (when I had my epic pro-crypto convo with family over stuffing and cranberry sauce) to put a number on my rising Fear Of Missing Out. As of 1/9/18 that amounts to:
                    
Initial Investment:    $3,000.00                 
Current Value:         $8,211.88                 
Weighted Return:    174%                
FOMO Index:         $5,211.88                 


I will update the FOMO index (and weep softly onto my keyboard) in any subsequent posts. 


Disclosure: As the previous section should have made clear, I do not own and have not transacted any Bitcoin or any other cryptocurrencies. My perspective is one of a highly interested market observer attempting to understand and contextualize these (relatively) new instruments against the backdrop of more traditional financial products.

[1] Apparently there are PawnCoins and PwnyCoins, already. Just like speculative fiction based on mutants and superheroes fighting in a post-apocalyptic wasteland, apparently all the good ideas are already taken.

2018 Trader Construction Kit Academic Review Program

The 2018 Trader Construction Kit Academic Review Program is now open for professors seeking a practical guide to developing the skills and techniques employed by professional traders at banks, hedge funds and other financial institutions. There are myriad experiential memoirs written by market heroes and countless desiccated math texts available, but until now there has been a dearth of basic, usable information that shows students how to develop a robust trading methodology that distills information into an actionable perspective on the future of price, evaluate implementation strategies, and develop a disciplined plan for accumulating and managing positions. If you have struggled to find an academic text that fits within your trading or market-related curriculum, please feel free to contact me at info@traderconstructionkit.com or use the form available here.

More Bitcoin Musings During the Futures Launch

Following up on my initial post on the nascent Bitcoin futures market (which can be found here), a few additional thoughts:

1. Given what I conjectured to be a small to non-existent cadre of naturals/hedgers with a vested transactional interest, I asked the question: Does anyone need Bitcoin? Given the design of the futures contracts, and indeed the properties of futures markets in general, the same question can easily be asked of the CBOE and CME products. One argument that has been made is that miners can use the futures to hedge production of Bitcoin and other entities can use them to lock in exchange rates for future payments in Bitcoin. They could, but the better question is whether or not they should.

Consider a Bitcoin miner that expects to produce one Bitcoin in January, but that likes the current December price and wants to lock in that value. The miner establishes a brokerage account and sells one Jan CBOE futures contract for $18,000. The initial margin required to hold a futures position will be a function of the exchange mandated minimum, plus any markup/adjustment demanded by the clearing broker to compensate for the riskiness of the counterparty and the product. The problem for the hedger is not usually the initial margin (though for thinly capitalized players, it certainly can be), but the variance margin that the clearing broker will require to cover the day-to-day fluctuations in value.

If on the second day the Bitcoin contract closes at a new high at $20,000, the miner will owe their clearing broker $2000 of variance margin. If they don’t pay, the clearing broker will close the position and the miner will be on the hook for the losses. Though the value of the future Bitcoin the miner will produce has also increased in value by $2,000[1], they will not be paid until they sell it in January. This mismatch of cash flows is called the Hedger’s Dilemma, and if taken to extremes can easily bankrupt a firm that has, theoretically, made a smart decision to mitigate their price risk.

2. A secondary question around the utility of the futures contracts is whether or not players accustomed to the totally anonymous, unregulated characteristics of Bitcoin (and the cryptocurrency space in general) would have the desire (or capability) to set up an account in a highly visible, highly regulated, dollar-denominated product.

3. I’m also curious as to the market-expanding effects of the futures contracts. In my prior post I attributed the rise in price of Bitcoin to the inflationary effects of an increasing amount of money chasing an (effectively all-but) fixed volume of supply. A futures trade requires both a buyer and a seller, but the potential open interest is theoretically unlimited. Willing short players could end up facilitating the participation of a large number of unrequited buyers desperate to establish long exposures.

4. Good poker players hate playing against novices, as they do not tend to react in predictable ways and often refuse to throw in their hand when logic suggests that they should. I wonder if this same skill-based dichotomy might manifest itself in the Bitcoin futures, which could ultimately end up as a trap for the highly anticipated barrage of “traditional” financial players eagerly anticipating their opportunity to short what they feel to be an insanely overvalued market. If the same buy-and-forget mentality starts to manifest itself in the futures markets, the pros could find themselves shorting into a wave of doctors and dentists who have no intention of closing out of their positions under anything other than catastrophic circumstances. So, if the long side of the market is basically pot committed with their Bitcoins, then who are the shorts supposed to buy their positions back from? Their only hope is to bid up the price to entice in other professional sellers. This could easily lead to a rather violent rolling stop out, if the market were able to gather a respectable volume of open interest and make a protracted move to the upside that would be painful to the financial participants with V@R and stop-loss limits to worry about. I’m certainly not saying it will happen, but the necessary dynamic does seem to be present in the market.

In summary: Based on the unique characteristics of the cryptocurrency space, it seems that the most obvious utility of the futures is as a secondary speculative instrument, not necessarily a hedging vehicle.

Full disclosure, I do not own and have not traded any Bitcoin, Bitcoin futures, or any other cryptocurrencies. My perspective is one of a highly interested market observer attempting to understand and contextualize these (relatively) new instruments against the backdrop of more traditional financial products.

 

[1] Which may not be true, given the futures-to-cash basis, which will not be a constant.

Bitcoin Musings on the Eve of the Futures Contracts

Based on the fact that I spent 30 minutes discussing Bitcoin’s utility as a store of value and the relative merits of the underlying blockchain technology at Thanksgiving dinner, it seems logical to collect and summarize my thoughts on the eve of the highly anticipated launch of the CME and CBOE futures contracts. In the interests of full disclosure, I do not own and have not transacted any Bitcoin or any other cryptocurrencies. My perspective is one of a highly interested market observer attempting to understand and contextualize these (relatively) new instruments against the backdrop of more traditional financial products.

There are a few key differences in how the CBOE and CME chose to define their respective instruments, the most significant of which are the contract sizes (1 Bitcoin for the CBOE vs. 5 Bitcoins for the CME), the intraday trading halt levels (10% and 20% vs. 7%, 13% and 20%), and the initial margin requirements (30% vs. 35%). On the surface, the CME seems to have designed a contract for larger, more sophisticated financial players with deeper pockets and an ability to manage intra-day risk, while the CBOE’s product seems geared toward smaller firms and/or individual investors. 

In Trader Construction Kit I assert that to be long run viable, a market must have a diverse group of participants, including natural players (frequently called hedgers) with a need to buy or sell to mitigate organic exposures, financial intermediaries like banks and merchants that facilitate transactions and transform risk for a fee, and speculators that seek risk for profit. Most markets are initially driven by the day-in, day-out transactional needs of hedgers, which are serviced by the banks and merchants, ultimately drawing in speculators that seek to profit from the inevitable price fluctuations. The cryptocurrency space (seems to have) evolved in reverse, with the speculators arriving first, then the banks and merchant players drawn in by the demands of their clients to participate in the space. The question remains, who are the naturals? In the early days of the market, it was possible to argue that the Bitcoin miners themselves were the naturals, with a long position that needed to be hedged. Given the reduced mining output relative to the total volume of Bitcoin extant, I am not sure that this is as operative an assumption now. Going forward, who needs the ability to transact in Bitcoin to facilitate their core business? 

Traditional market participants bemoan Bitcoin’s lack of fundamental information to analyze to develop a view on price. How do you trade a product with no fundamentals?!? Bitcoin does not have no fundamentals, it just doesn't have the same fundamentals as traditional currencies. For an instrument that is converging to a fixed volume of tradable supply, the key variable is money flow into/out of the product. For those with a long memory, this is the same inflationary force that drove oil prices from the low $60.00 range up to $145.00 in 2007-08 as the formerly $50B market tried to digest an incremental few hundred billion dollars of investment from pension funds desperate to increase their commodity allocations. Also worth considering, when those same funds re-allocated away from commodities after the financial crisis, the price of oil immediately crashed back down again. So, the first thing to watch is the relative money flows into/out of the space and the number of accounts opened up at the exchanges. 

A second variable worth considering is the relative percentage of Bitcoin held by “investors” vs. “traders”. According to recent media reports, the Winklevoss twins claim to have never sold any of their initial $11M investment in the space, which is currently valued at around $1B. Given the relative level of zealotry endemic to some of the early market participants, I am sure they are not the only ones in for the long haul. Given that, how much of the approximately $250B of Bitcoin is actually available to the market to absorb incremental buying and selling? Trying to purchase $1B of Bitcoin will have an entirely different price response if the available transactable volume is $100B vs. $10B. 

The law of one price has yet to be fully enforced by arbitrage agents in the cryptocurrency markets, leading to potentially significant simultaneous exchange-to-exchange price differentials. This makes sense, given the relative developmental state of the market, as much of the recent activity has been driven by the entrance of a large number of retail (i.e.: small and unsophisticated) accounts that will likely participate in and transact on only one exchange, which can lead to isolated pockets of intense buying/selling pressure that locally distorts price. The introduction of the CME and CBOE contracts may actually short-run exacerbate this phenomenon, but should in the long run help to stabilize prices via increasing the participation of sophisticated financial players for whom multi-exchange arbitrage is a standard business practice.

I am extremely curious to see what effect introducing the futures contracts will have on the existing cryptocurrency markets. Many members of the “traditional” financial markets view Bitcoin as an insane speculative bubble and assert that the ability to freely enter into short positions afforded by the futures market will instantly crush valuations. While it is certainly possible, I do not believe that an instant sell-off is as obvious an outcome, particularly given the (likely) small relative size of the futures market compared to the “tradable” portion of the volume held at the largest Bitcoin exchanges. There will likely be a protracted struggle to determine which is the tail and which is the dog, going forward. I also suspect that the fragmented high-volatility, low-liquidity Bitcoin market will provide unique challenges for financial players, particularly around survivable position sizing, efficient entry/exit execution, and institutional risk management. One distinct advantage of being an “unsophisticated” buy-and-forget individual investor oblivious to the minute-to-minute price fluctuations is not being forced out of the market when their overly-large position blows through their V@R and stop-loss limits fifteen minutes after they put it on. Given the prevailing level of volatility endemic to the cryptocurrency space, this is an all-too realistic possibility.

CBOT futures go live December 10th, with the CME futures following on December 17th. Bring your popcorn.

A Comparison of Current Academic and Industry Pedagogies for Developing Traders

I have published a paper on Social Science Research Network (SSRN) that compares the current academic and industry pedagogies for developing traders, which can be found at:

https://ssrn.com/abstract=3057447

Abstract

There is a gap between the knowledge and skills present in graduates of top-flight finance programs and the demands of a modern trading desk. This paper compares the development methodologies common in industry and academia and proposes incremental modifications to existing finance curricula that would produce stronger graduates more able to move directly into commercial positions at financial firms. Changes to introductory finance classes, real-money portfolio management courses, and market simulation programs are discussed.

Though the paper principally addresses the academic community, it will be of interest to industry practitioners and students aspiring to a career in the markets.

How to Prepare for a Trading Interview – 2017 Edition

For current university students and recent graduates, preparing for a trading interview will involve a substantial amount of industry and company-specific research. The candidate must, at a minimum:

1.    Know the Industry.
2.    Know the company and its primary business.
3.    Have a sense of the immediate evolutionary challenges the firm is facing.
4.    Know the people they will be speaking with, their backgrounds, the markets they inhabit, and the products they trade. 
5.    Know as much as possible about how the market is traded at the target firm, and how the candidate’s skills make them a good match for that product.
6.    Prepare for some of the obvious questions they should expect to be asked.
7.    Prepare for the programming & data science requirements of the job.

Know the Industry
The opportunities available and the types of business transacted are, to a great extent, determined by the evolutionary state of the industry. Early-stage markets offer the most opportunities for rapid advancement for candidates with an entrepreneurial mindset and a willingness to innovate in an evolving operational environment. Fully-evolved markets have established career paths, with measured progression based on the mastery of and deployment of established knowledge sets. A candidate needs to know the evolutionary state of the industry they are targeting to calibrate their expectations of the potential career progression available to them, and to understand the company’s expectations of their initial and to-be-developed skill set. 

Know the Company
In Trader Construction Kit I focus the majority of the second chapter on describing the market activities of four categories of market participants: Hedgers, Merchants, Financials and Speculators. Each category participates in a market for specific reasons, engages in different types of risk-shedding, risk-modifying, or risk-taking activities, and hires traders will different skill sets to implement their business plan. A candidate must know what type of firm they are speaking with and understand the basics of their core business and corporate culture. 

Have a Sense of the Immediate Evolutionary Challenges the Firm Faces
There is a lot of change going on in the world of finance and trading, at the moment. The Europeans are grappling with the implications of MiFID II, the British banks are trying to plan for the continuity of their business under all of the possible permutations of Brexit, the Americans are navigating a sea change from an environment of increasing regulation to one of possibly decreasing oversight, and everyone is dealing with the accelerating impacts of technology (AI, algorithms, blockchain, cryptocurrencies, etc.) on their core businesses. While a candidate will not be expected to be a subject matter expert on every last regulatory nuance, they will be expected to have a general sense of what is coming and how it may impact the business unit they are interviewing with. 

Know the People and the Markets
In a Google and LinkedIn world there is no excuse for a candidate not having a basic familiarity with the backgrounds of their interviewers. The person arranging the schedule will generally provide a list, if asked nicely by the candidate. The candidate must know each interviewer’s position within the company to understand their function, their implied perspective, and develop a sense of what sorts of questions to anticipate. A risk manager with a Masters in physics and a PhD in quantitative finance will have entirely different concerns and ask entirely different questions than a proprietary trader with a background in the crude oil pits and scars on his knuckles. The candidate must find a way to be relatable to both.

A candidate should expect to speak to the head trader, their lieutenants (one of whom will probably be the hiring manager), a junior person to provide a skill-set comparison with a near-peer, and potentially members of the risk, analytics, and compliance groups. If that sounds like a lot of people, it is, and an aspiring trader should expect a full day of half-hour to hour long conversations with one or two people at a time. It can be difficult to maintain focus, but in the vast majority of cases the candidate must leave a positive impression on every interviewer and really shine with the one or two shot-callers they meet.

Know How They Fit In as a Candidate
In Chapter 1 of Trader Construction Kit (which is available here), I list the positive characteristics of successful traders and the negative traits of unsuccessful ones. The candidate must accurately assess their unique strengths and weaknesses and how they apply to the demands of the trading environment at their target firm. If the candidate wants to build bleeding-edge algorithms at an industry-leading quantitative hedge fund, they had better really know how to code or they will be laughed out of the room. Ditto for an unassertive pit trader, a non-mathematical option trader, a disorganized market-maker, or an indecisive directional trader. There is no shame in being a poor fit for a particular job at a particular firm. There is a tremendous amount of shame in showing up for the interview either not knowing that, or attempting to pass oneself off as something they are not. 

Prepare For the Obvious Questions
A current student or recent graduate with little to no practical trading experience to be quizzed on should expect the standard probability and logic based questions. Read up on the Monte Hall question, basic conditional probability problems, and (my personal favorite) the TV Question. The candidate should expect questions about sports played, team activities, and their propensity for gambling and other risk-taking behaviors. In lieu of actual experience, the traders will want to see that the candidate can logically process information and make decisions quickly under stress. At some firms it is very fashionable to manufacture an artificially stressful environment to test the candidate, others will prefer a more collegial, conversational approach.

The candidate should also have at least a superficial familiarity with the benchmark informational resources for the market, both in terms of the standard educational texts and the book/blog/site/news of the moment that everyone is currently reading or talking about. Giving a blank stare to an interviewer who name-checks Nassim Taleb or references The Big Short is a big negative. A list of some common resources that an aspiring trader can investigate to help them prepare for an interview (Trader Construction Kit among them) can be found here.

Prepare For the Programming & Data Science Requirements
In 2017 the incremental must-have skills on the trading desk are programming and data science. Python is far and away the platform of choice for most on-desk development, and its large library of pre-existing code modules like NumPy, Pandas, and Matplotlib make it relatively easy to manipulate data and produce usable results. Firms that employ AI, Deep Learning, or any sort of non-traditional data set analysis will employ significantly more esoteric and powerful tools. While it is true that most of the heavy programming work will be done by highly specialized CS and Data Science graduates, on a going forward basis not being able to code will become akin to not being able to read or write. I believe that this evolution will happen very quickly, and that as trading becomes increasingly machine driven, the person most able to transform data into actionable information will be the person seen as adding the value to the organization. One relationship that will not change in the future is that adding value = getting paid.

Fluency in Python and an aptitude for Data Science will also serve as a valuable safety net in case the candidate is not hired as a trader. It is very common for even a top-notch candidate from a strong academic program to be hired into the firm in a non-commercial support position, either as an assistant trader, analyst, risk-manager or deal structurer. Support functions typically serve as a combination apprenticeship and extended interview for the trading desk. Making the transition from a support role to the trading desk presents its own set of unique challenges, which will be the subject of a follow-up post. 

Advice to the Graduates Starting on a Trading Floor

To succeed as a trader, a trainee must first navigate the minefield of their first few months on the job. It is important enough that in Trader Construction Kit I devote an entire chapter to the challenges of assimilating into a trading desk. As the class of 2017 prepares to shake off their crushing post-graduation hangovers and seek their fortunes in New York, Chicago, Connecticut, London, Paris, and Frankfurt, here are some pieces of practical advice that I wish I’d had at the start of my career:

 

1.    It’s not going to be like a job at a tech start-up.

2.    A new hire is no longer a beautiful and unique snowflake.

3.    Trainees don’t have a name until they earn one.

4.    A junior trader will need support from a variety of other groups to succeed, so better start cultivating it.

5.    There is a massive difference between academic understanding and practitioner mastery of the same material.

6.    Learning and assimilating the corporate culture is everything.

7.    There are a million ways to self-sabotage, choose none of them.

8.    Opinions are formed very rapidly, and second chances are rarely given.

9.    There are different rules for different people.

10. It’s a competition, so start competing.

 

1. It’s not going to be like a job at a tech start-up.

In contrast to well-funded start-ups where seemingly every n00b coder is welcomed with an avalanche of corporate-logo swag and a personal robot smoothie valet, new arrivals on a trading floor will typically face an altogether less hospitable greeting. In the best-case scenario, they will get the desk, chair, and computer previously employed by the most recent person to get fired. In a firm where “our most important asset is our people”, they may rate a terse “Hey” from the stressed-out zombie sitting across from them and, maybe, directions to the bathroom.

This coddling gap can be hard to stomach when, after being operatically berated by a belligerent MD with a hair-trigger temper, the recent grad sees an Instagram selfie by their ex-roommate on a kite-sailing boondoggle in St. Barthes to celebrate the killer launch of their new mobile app for pets. Guess who just happened to run into the Hadid sisters on the beach! Like? No! Do Not Like!

 

2. A new hire is no longer a beautiful and unique snowflake.

MBA students from top-flight universities have been groomed to be the future leaders of the world, special people with unique talents and limitless potential. PhDs from top-flight universities are even more special, like magical unicorns covered in genius dust. Imagine how they must feel when they arrive on the trading floor, chock full of potential and genius dust, only to be called a dumbass by a Cro-Magnon trader with a Bachelor’s degree from a community college. How dare they! I have an asteroid named after me. A big one!

The somewhat depressing revelation for many expensively educated hires is that, at a top-flight financial institution, gaudy degrees and cited contributions to basic science are extremely common. “Chess Grandmaster? We have four already. Now that you’re here, we have enough for a basketball team. You can play the String Theory PhDs from Risk Management.”

 

3. Trainees don’t have a name until they earn one.

Nobody on a trading desk bothers to learn a new person’s name until they do something to distinguish themselves, good or bad. To compensate, most new employees end up with some sort of a behind-the-back nickname, which can range from cruelly dehumanizing to totally bad-ass. Sure, everybody wants to be “The Punisher” or “El Diablo”, but sadly, most people end up as “Tuna Sandwich Guy” or “Lax Bro #4”.

They shouldn’t get upset, and they shouldn’t take it personally. It happens to everyone. When they become a senior trader (if they become a senior trader), it will be their turn to be too busy grinding their teeth and staring in horror at the wreckage of their crude oil position to pay attention to what’s-his-name sitting across from them wearing a Brine Lacrosse polo shirt and eating a tuna sandwich.

 

4. A junior trader will need support from a variety of other groups to succeed, so better start cultivating it.

As seen in this excerpt from Chapter 16 – Navigating the Corporate Culture of Trader Construction Kit:

“The modern professional trader is almost never a lone wolf. At anything other than the smallest shops, he will rely on a variety of support functions from deal entry to risk management to analytical and operational support. The ability to productively interact with the other groups on the floor and the other traders is critical.” [1]

Building those bridges as a new hire can sometimes be tricky, particularly when dealing with on-desk analysts and risk managers that were never considered (or passed over) for the open trading job. They will often choose to take out their frustrations on the person who was hired in a passive-aggressive fashion. This is doubly problematic if the newly-minted trader relies heavily on them for informational inputs, or is subject to their risk management oversight. There is no easy solution, but one productive approach is to remind the slighted analyst or risk manager that the only constant in a trading organization is turnover, and that maximizing their interactions with the desk (including its newest inhabitant) is the surest way to improve their chances at the next job.

 

5. There is a massive difference between academic understanding and practitioner mastery of the same material.

Some new hires (particularly those with asteroids named after them) feel compelled to prove this point early in their career by voluntarily lecturing the senior traders and management on their deep, penetrating insights into the market gleaned from their Advanced Topics in Finance capstone project. This tends to go poorly. Almost by definition, nothing a trainee trader says for the first three to six months is good for anything other than the amusement of the rest of the desk.

One of the primary tasks of any new trader is to identify their particular knowledge gaps relative to their more experienced colleagues, then seek to close them as rapidly as possible. They must read all of the relevant industry research and analysis, study the benchmark texts on trading (a list of resources can be found here), ask questions, and accept all offers from more experienced traders to sit with them and have them explain the nuances of their market. The lack of practical market knowledge is the most glaring deficiency common to all new hires, and it is completely understandable. You can read as many books about proper swimming technique as you want (including my forthcoming 624 page textbook, Swimmer Construction Kit…just kidding), but that body of theory does not compare with what you learn in five minutes when you jump in the ocean and try to keep your head above water. There really aren’t any shortcuts to understanding how a market works, which comes with time, focused observation, and continuous immersion.

 

6. Learning and assimilating the corporate culture is everything.

Again, from Chapter 16 – Navigating the Corporate Culture of Trader Construction Kit:

“The trading floor is a workplace unlike any other, and can vary significantly from firm to firm. The atmosphere on the floor is determined by the trading culture, and the trading culture is determined to a great degree by the head trader and his lieutenants. Some floors are hushed libraries of academic intensity, silent except for grinding teeth, mouse clicks, and the soft snap of Advil and Adderall bottles being opened and closed. In a more clubby atmosphere one might see formerly staid bankers slouching around at a hedge fund in polo shirts and deck shoes, alternating world-weary market chatter with shot-by-shot analysis of the last round of golf. At a global financial powerhouse the floor will be a football-field-sized maze of desks, screens, and over-dressed stress cases ready to out-intense the other ex-lacrosse bros for a chance at the Associate Junior Vice-President slot opening up next fiscal year. At a scrappy up-and-comer the trading room will be furnished with homemade plywood desks and lawn chairs, and the three founders will try to out-gamble their cash burn in their shorts and flip-flops while playing first-person shooters on the office Xbox.

Succeeding as a trader is dependent on being accepted on the floor, whatever its quirks and characteristics. It may feel disconcertingly like being back in high school.” [2]

Please note, I’m not suggesting that a conformist attitude is in any way mandatory. Ideally, the trader would have researched the firm’s culture as part of their interview preparation (some thoughts on that here) and chosen a firm that was a good match for their personality. What I am saying is that the early days on a trading floor are not the time to ruffle feathers, pick fights, or in any way piss off the people that the junior trader desperately needs to learn from to survive. An awareness of and sensitivity to the unwritten cultural rules will go a long way to helping the new hire integrate onto the desk.

 

7. There are a million ways to self-sabotage, choose none of them.

Chances are, a recent graduate at a finance firm will be living in a new, exciting city and getting their first taste of real money, which often leads to all sorts of extracurricular bad behavior. Beware, it is entirely possible to party yourself out of a job, particularly when taking into consideration…

 

8. Opinions are formed very rapidly, and second chances are rarely given.

One last excerpt from Chapter 16 – Navigating the Corporate Culture of Trader Construction Kit:

“As discussed in Chapter 14 – Managing Positions, sooner or later every trader will have to deal with a significant losing position. Young traders are particularly vulnerable, due to their relative lack of experience anticipating dangerous market conditions, aptitude at handling them, and absence of built-up credibility with the desk and senior management.

The first disastrous trade is frequently a career-defining moment for a young trader. If he manages the problematic position efficiently and acquits himself in a professional manner, he will earn respect and a continued ability to do business. Making a bad situation worse and exhibiting poor behavior will likely ensure that the trader’s first bad trade will be his last.” [3]

Most early-career traders fail to understand exactly how thin the ice beneath their feet is during the first few months until they find their footing and start to produce meaningful profits for the firm. The most common mistake is over-aggressively sizing their positions and risk tolerances relative to those of their more experienced colleagues. For a senior trader with a $50M target and $20M annual stop-loss, losing $1M is a bad day at the office, nothing more. The same loss for a junior trader would likely be devastating, particularly if they compound the error by not exercising good discipline, losing control of the exposure, and failing to show the proper degree of respect for the firm’s capital.

 

9. There are different rules for different people.

As I mentioned in the recent post titled Making The Transition from Support Group to Trading Desk (which can be read here):

“It can be difficult for support staff to understand (or stomach) that there are two sets of rules, one for the trading desk and one for everyone else. Profitable traders are often granted an almost incomprehensible degree of behavioral latitude, frequently going unpunished for actions that would mean discipline or dismissal for an employee that wasn’t currently up $50M for the year. It’s not right, and it’s not particularly fair, but it does happen.“

Trading is all about production. A proven money-maker, particularly a big hitter, will quickly develop a level of importance to their firm that will obscure almost any negative characteristics or actions. An unproven junior trader will not be cut anything like this level of slack, and it is critical that they understand this before overstepping their bounds and committing a damaging faux pas. They must also be aware that the latitude that profits grant is quickly erased by drawdowns and underperformance. It’s all jeans and flip flops and coming and going as you please when you’re up, but the second the P&L goes negative its back to 12 hour days in a suit until you earn it all back.

 

10. It’s a competition, so start competing.

I characterized the first few month on a trading desk as a minefield, which would logically suggest an approach built on caution, deliberation, and measured progress. The problem is, it actually a race through a minefield. Being first to get up to speed on the market means first to get a trading book, which means first to generate P&L, which means the best chance to be the top performer at the Junior/Assistant Trader level, which means the first to be promoted to Trader, etc. Everything on a trading floor is first, fastest, or best, and the reward for being any or all of those is money. Lots of money. Better get going. Chances are someone in your class read this post an hour ago and is already on page 34 of Liar’s Poker.

Good luck.

 

 

[1, 2, 3] Excerpts from Trader Construction Kit Copyright © 2016 Joel Rubano. All rights reserved. No part may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without permission in writing from the publisher, except by reviewers, who may quote brief passages in a review.

The Importance of Developing a Trading Methodology

In the first chapter of Trader Construction Kit (which can be read here) I assert that succeeding as a professional trader is a two-part problem: personal evolution to become the best possible risk taker and developing, refining and deploying an efficient process for interacting with the market. Given the recent widespread popularity of Behavioral Finance, most aspiring traders are aware of the need to improve their decision making and avoid common biases in risk taking behaviors. There is significantly less material available on how to develop a robust trading methodology, which I describe in idealized form in the following excerpt from the chapter:

  • The ideal trader has a clear sense of what she is trying to achieve at all times.
  • The trader expects a particular market response when a base set of fundamental and technical conditions are disturbed by incremental change or the influence of external stimuli. This informed perspective on the future of price is called a view.
  • The trader considers a variety of strategies to implement her view, selecting the one with the closest response to the underlying driver with the best potential reward, the lowest probable risk, and the best performance characteristics.
  • The trader sets the position with a defined profit target and a stop-loss.
  • The trader monitors the position for changes to the underlying thesis while maintaining an alert, intellectually engaged but emotionally detached state.
  • If action is required, the trader executes with the maximum possible efficiency.
  • The trader evaluates the results and adjusts the operational parameters (trade selection criteria, stops, targets, etc.) of the methodology as necessary.
  • Repeat.[1]

 

Exploring each point in greater detail, we see that:

A trader must have a clear sense of their goals, as without a defined set of expectations it is impossible to calibrate their allocation of resources and relative level of aggression. A firm grasp on their capability to take risk is essential when formulating position sizes and evaluating resource-intensive trading strategies.

A trader must incorporate all of the available relevant information into their decision-making process, given their stylistic predilections. While I feel that it is logical to incorporate both fundamental facts and technical information, many traders prefer to start with a more curated set of purely fundamental or technical inputs. Whatever works for the individual. One universal constant is that the trader’s analysis and interpretation of the informational inputs must lead to their view on the future of prices, not be an after-the-fact justification for a pre-conceived notion that the market is going higher or lower.

Once the trader has developed a view of the market they must evaluate the options available for establishing an exposure to capitalize on the anticipated price fluctuation(s). Different traders will have different resource allocations and products approved for use, and their ability to employ them will be a function of their relative year-to-date performance. A trader must consider all potential implementation strategies, evaluating each alternative on how much capital it puts at risk, the potential reward, and the unique performance characteristics that will impact its response to market fluctuations. The ability to accurately assess the relationship between risk and potential reward is the key determinant of a trader’s long-run success. Typically, a trader will require a reward that is a multiple of the amount they have put at risk to justify a position.

Having evaluated a variety of options to arrive at the optimal strategy to express their view, the trader must develop a plan to implement it in the market. A good trading plan will include (among other considerations) a stop-loss level beyond which the trader will concede that the position is not working and exit and profit target where they will happily book their winnings. The stop-loss and profit target must be derived prior to establishing the exposure, as this allows for a more clinical, unbiased assessment.

A trade is an exposure designed to express a view on the future of prices, a perspective that was informed by pre-trade analysis of the market conditions. Market conditions are not constant. The trader will have to remain immersed in the market and alert for any changes to the underlying drivers of their view. If the evolution is unfavorable, they must exit the position immediately.

When entering and exiting the positon the trader will seek to execute as efficiently as possible to minimize slippage and other transactional costs, which act as a tax on the profitability of the exposure.

Once the position has been closed and the P&L realized, the trader will forensically re-examine their decision making across the entire process, regardless of positive or negative outcome. While this type of methodological tuning is valuable for experienced traders, it is absolutely critical for younger traders who are still developing their approach to the market.

When all is said and done, the trader will start over at the beginning: watching the market, taking in information, and using it to re-formulate a view of the future of price.

From this basic blueprint the trader will add, subtract or modify elements as needed to adapt it to the demands of their particular market, take maximum advantage of their unique strengths, and de-emphasize their inherent weaknesses. Every trader should seek to leverage their comparative advantages relative to their peers in the market, wherever and whatever they may be. If they are a talented fundamental analyst, their methodology should over-weight fundamental inputs when deriving a view of the market. A skilled option trader might be able to contemplate constructing complex non-linear positions that might not seem as attractive or viable to a directional or spread trader, etc.

Developing a trading methodology is a complicated topic, and it would not be a stretch to claim that the majority of the 624 pages of Trader Construction Kit are dedicated to a step-by-step explanation of the process. For readers interested in a deeper dive into the material, I will be publishing a series of excerpts from Trader Construction Kit starting with Chapter 3 – Fundamental Analysis and continuing through Chapter 14 – Managing Positions & Portfolios. Each excerpt will be available here for one week, and will be replaced by the next chapter the following Monday.

 

[1] Excerpt from Trader Construction Kit Copyright © 2016 Joel Rubano. All rights reserved. No part may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without permission in writing from the publisher, except by reviewers, who may quote brief passages in a review.

 

Making the Transition from Support Group to Trading Desk

Preparing for a trading interview (described here) is a like cramming for an exam, a short period of intense preparation followed by a draining day-long session that demands total focus and maximum effort. Sadly, most candidates will fail this test. It need not be the end of the road, however. Applicants passed over for trading opportunities can often get a second bite at the apple by joining a trading firm in a support capacity, then seeking to move onto the desk. Making the transition to a trading seat from a support role will take preparation, a plan, and a significant amount of discipline and endurance, and the relative success or failure of the effort will often hinge on the individual’s interpersonal skills as much as their technical knowledge.

 

Newly-hired support staff will be slotted into the firm in either a front office, middle office, or back office role. The front office is the commercial function of the firm, encompassing the trading and origination desks and personnel that work closely with them, including dedicated on-desk analysts, members of the structuring group, and senior fundamental and quantitative analysts. Middle office functions include the risk group (though it is technically outside of the trading reporting chain), the portion of the analytics groups that does not report directly to trading, and the operations group that handles the scheduling and delivery of physical transactions. The back office handles purely administrative functions, and is composed of the credit group, the legal group, the contract administrators, and the compliance group. The closer to the desk the aspiring trader starts, the better.

 

Support staff should expect to receive little help in their progress toward the desk from their current management, as the heads of support functions are concerned with maintaining a smoothly operating group, not serving as a training ground for another business unit or facilitating the aspirations of their employees. It will be necessary for the aspiring trader to carve out some portion of their day to work on building relationships with the members of the trading desk and acquiring the skills and market knowledge necessary to progress, which in practice may mean coming in early and/or staying late to actually complete their assigned work.

 

It is critical for support staff to understand that the onus will be on them to drive the process. As seem in this excerpt from Trader Construction Kit:

 

“There is one huge misconception that prevents people from being hired onto a trading desk from some other area of the company: aspirants believe that some innate quality of theirs will shine through as they toil away on the cover sheets for their TPS reports, that senior management will somehow identify it through unspecified means and, in a stirring act of trust and belief, whisk the employee off into a fairytale world of four-screen desks, turret phones, and lavish compensation. It does not work like that. Anyone seeking to escape support-staff hell will have to do the following:

  1. Make the management of the trading desk aware that he really wants to be a trader and would strongly consider anything up to and including murder as a means of career advancement.
  2. Make sure he understands the requirements of the position he is seeking, and show that he is attempting to evolve in that direction, to the maximum extent possible. This is the crux of the matter. Nobody cares how good of a confirmations analyst or accounts payable coordinator the anonymous drone from down the hall is; it has no bearing on their capability to fill a trading seat.
  3. Be engaged in the firm’s business, show interest, initiative, and make the most of any opportunity. It is difficult for a person in a support function to be current on the market, but he can at least know which markets the firm participates in, etc.”

 

The goal is to be seen as the first in line for the next trading vacancy by the trading desk. Support functions are powerless to push an analyst or risk manager onto the trading desk. Senior management of the firm can facilitate a move, but are generally loathe to anger the producers by shoving someone into the group that they may not want. The desk has to feel the candidate is a good fit and can add value to consider bringing them on, otherwise they will go to the external market. Every internal candidate will be competing against the universe of potential external hires on the basis of being a (probably) cheaper known quantity with upside potential. If the desk does not know the candidate and believe that they have something to offer and room to grow, they will hire from outside the firm.

 

There are potential downsides to being on what amounts to a multi-year job interview. Familiarity breeds contempt, which cuts both ways. The day-to-day interaction with the trading desk gives the traders the opportunity to form opinions about the analysts, etc. There is a need for the support staff member to guard and curate their professional image over an extended period of time, which can be challenging. Being on point for eight hours of interviews is hard, maintaining that level of focus for eighteen months is extremely stressful. Worse yet, seventeen months and twenty nine days of focus, dedication and unwavering competency can be completely undone by one bad day, blown presentation, stupid argument, or regrettable social interaction. It can be difficult for support staff to understand (or stomach) that there are two sets of rules, one for the trading desk and one for everyone else. Profitable traders are often granted an almost incomprehensible degree of behavioral latitude, frequently going unpunished for actions that would mean discipline or dismissal for an employee that wasn’t currently up $50M for the year. It’s not right, and it’s not particularly fair, but it does happen.

 

One of the biggest (and most inexplicable) mistakes support staff make is to loudly, publically assert that they should have a trading job because they are smarter, have more latent talent, or have a more advanced degree than the people currently on the desk. It normal for nascent markets to reward different behaviors and skill sets than developed markets require, and each successive generation of analysts and traders will invariably be better educated and start from a higher informational baseline than their predecessors, sometimes to a ridiculous extent. This can be extremely frustrating for newly-minted PhDs expected to take orders (and abuse) from a comparative Cro-Magnon with a low-rent bachelors degree who lucked into the last good trading job right before the market evolved. Highly educated newcomers would do well to remember that every successful trader has developed (or assimilated) an experientially-based body of knowledge and technique for operating in the market, one that they will need to master to take their place on the desk. Alienating the only source of information is a very, very bad idea.

 

Support staff need to be aware of, and take maximum advantage of, their opportunities to interact with the trading desk and learn the firm’s business. If a senior trader offers to explain something about the market, make time to listen. If the head of analytics offers research that informs the traders’ decisions, be sure to read it. If there is a mentoring program, join and take full advantage of it. If there is internal training, sign up for it. Do not squander opportunities. Help that is refused and resources not taken advantage of will not be re-offered, and members of the trading desk will definitely remember analysts who bemoan their lack of advancement but were “too busy” to sit on the desk, go to a class, or read a research report.

 

In addition to the market and product-specific knowledge that support staff will have to assimilate by osmosis from the traders and on-desk analysts there will be a great deal of basic information that they will have to master. A list of resources (Trader Construction Kit among them) can be found here.

 

An aspiring trader temporarily trapped in support-staff purgatory should use their newfound perspective to honestly re-assess themselves relative to the demands of the job in general and the particular way it is practiced at their firm. As the saying goes: Everybody likes sausage, until they see how it is made. Seeing firsthand what the job entails and the demands it makes of its practitioners has led many aspirants to realize that it really isn’t for them, after all. Figuring that out before making a committing move to the desk is a mature, sensible decision. A productive career as a risk manager or analyst at a successful firm will frequently be significantly more lucrative, in the long run, than an unsuccessful stint on a trading desk followed by a swift termination.

 

In summary, support staff must do the following to transition to the trading desk: 

  1. Take responsibility and drive the process, to the maximum extent possible, as their current job will typically not have an established evolutionary path to the trading desk.
  2. Understand that there will be a substantial amount of self-education, both in terms of specific markets and products and general trading information.
  3. Immerse themselves in the culture of the firm and the trading desk, in particular.
  4. Take advantage of every opportunity to work with and learn from members of the trading desk, both to develop knowledge and to build relationships.
  5. Be professional and learn to deal with adversity instead of becoming frustrated and giving up, lashing out, or finding any one of a hundred ways to self-sabotage their progress toward their goal.

 

Aspiring traders must dedicate themselves to the process, work to increase their knowledge base, and take advantage of every opportunity to make the small, incremental steps that will ultimately lead to their jump to the trading desk.

 

 

 

Excerpt from Trader Construction Kit Copyright © 2016 Joel Rubano. All rights reserved. No part may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without permission in writing from the publisher, except by reviewers, who may quote brief passages in a review.