Sunday, December 06, 2009

Lessons for Developing Traders: More on What Moves Markets

In the first post in this series, I offered a perspective on what moves markets that I wish I had learned during my early years trading. In this follow up post, I will offer a second insight that I wish I had learned in those formative years: what moves markets over short time frames.

While large institutions move money across global regions and asset classes, creating large trending moves, the factors that move markets over a time span of minutes to hours are quite different. Understanding how market participants are segmented by the time frame of their participation is crucial to interpreting market movement.

Here's a crude analogy: Suppose you are standing in the ocean and someone asks you what makes the water move around you. You would be right to mention the moon and its effects on tides and patterns of waves. Of course, you might also be right to mention winds and local climate conditions, particularly if a storm were brewing. Then, too, you could take a look at the kids splashing in the water all around you and notice that they were contributing quite a bit to the water's movement around you.

Markets are like the ocean: there are longer-term forces that affect supply and demand, and there are also more immediate, local forces. It is the interplay of these forces that creates the movement we observe. If we look immediately around us--a few feet in each direction--the tides might account for little of the movement relative to the splashing of all the people surrounding us. If we look across the broad expanse of ocean, all we'll see are the waves and the effect of the winds and tides.

The short-term trader is like the person surrounded by splashing swimmers: the turbulence in the immediate environment is created by liquidity providers, also known as market makers. They are the ones who offer shares or futures contract for sale and who put out bids to buy. Their goal is to profit from immediate movements around the latest bid and offer price, including the spread between bid and offer.

What I wish I had understood better early in my career is that, while institutions (and global flows of capital) dominate markets over long time frames (the tides); it is the liquidity providers that dominate trade from minute to minute (the splashing). While fundamentals win out over a period of years, the short-term movements of markets are determined by the sentiment--the buying and selling biases--of market makers.

In the past, the market makers were traders on the floors of the exchanges. Then, they increasingly became proprietary traders in electronic markets. Most recently, they have become computer programs, executing sophisticated algorithms to exploit imbalances in the order book.

When I first came to Chicago to work full time with prop traders, I was astounded that few of the traders made active use of charts and technical tools for decision support. Yes, they looked at charts for broad reference, but the bulk of their attention went to depth-of-market (DOM) displays that constantly updated the number of contracts being offered and bid and various price levels. It was the flow of bids and offers in and out of the book--order flow--that showed the traders whether buyers or sellers were coming into the market.

For instance, if the prop traders saw bids firming up and a couple of large offers come out of the book, they would quickly buy and then work an offer a bit above the market. When the offer was lifted, they would have a one or two-tick winning trade. All day long, those ticks added up, particularly given the leverage available to the prop firms. There were situations where traders would trade all day like that, barely ever looking at a chart, and barely even knowing the specific price of the index they were trading. All they were seeing were bids and offers above and below the market and trading those.

As liquidity providers became bigger and bigger, they controlled more size close to the market. They could hold large bids, for example, at several price levels below the market's current price. All it would take is a simultaneous pulling of those bids and firming of offers above the market to drive the price down tick after tick after tick. That, of course, would scare out other traders; it might also entice some sellers into the market, thinking that a fresh downtrend had begun. Little did they realize that the liquidity providers were working large bids even further down the ladder, picking up contracts at very good prices. As they firmed up those bids, no further sellers materialized, and the market would bounce right back toward where it had begun. Splash, splash.

What I didn't realize as a new trader was how to think like a price maker, rather than a price taker. To succeed at short-term trading, you have to think like a market maker, not a retail customer buying bids and selling offers. That means understanding order flow, not just the movement of price on a chart. In recent times, that also means understanding how algorithmic programs can move markets up and down, without necessarily changing the underlying fundamentals of markets.

Indeed, when market makers move prices artificially high in a falling market or artificially low in a rising one, unusual opportunities are created for fleet-footed, perceptive traders. Opportunity exists in the crevices between those participants at different time frames: a lesson crucial for developing traders.