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The New Commodity Trading Guide: Eliminating People

George Kleinman discusses the cost savings and other benefits of electronic trading.
This chapter is from the book

Eliminating People

  • “Most of the world’s ills would be cured with one three-day open season on people.”
  • Ernest Hemingway
  • “They’re not just getting rich...they’re getting even.”
  • Trading Places (1983)

An electric tension fills the air as Louis Winthorpe, III and Billy Ray Valentine muscle their way through the crowd of traders lining the New York Board of Trade’s frozen concentrated orange juice (FCOJ) trading pit. The traders are sweating from the heat generated by more than 100 tightly packed bodies, nervous with the anticipation of what’s to come. The clerks manning the phones surrounding the pit are on high alert.

The crop report will be released in just minutes. When those numbers are out, the market will move big time, creating and destroying fortunes in the process.

Winthorpe and Valentine are now standing shoulder to shoulder with other traders eyeing their arch nemesis—the ultimate slime ball, Clarence Beeks. Beeks believes he already knows the actual crop report numbers. He illegally obtained an advance copy of the report in his quest to corner the orange juice market on behalf of the infamous Duke Brothers. However, our heroes learned of Beeks’s plan: They managed to steal the real crop report back from Beeks and secretly delivered him a fake version.

The “real” crop report will show a record-large orange harvest, resulting in huge supplies that will ultimately cause the traders to yell “Sell!” Beeks believes the numbers in his false report and will be looking for the orange crop numbers to be sharply lower. He is planning to “Buy!” in his quest to corner the orange juice market for the Dukes.

Futures are traded on margin, with only a small deposit required to purchase a large amount of an asset. It’s just as easy to short—to sell first and then buy back later (hopefully lower)—as it is to be a buyer. Commodities can be very volatile, particularly on crop report day.

The opening bell rings and immediately the decibel level explodes. All trades in the pit are made by the “open outcry” process where the traders yell out their bids and offers. Beeks starts hitting all offers, screaming “Buy, buy, buy!” Most of the traders in the pit are merely sheep looking to hop on for the ride. Seeing Beeks bidding the market up, they believe he knows something and join in his buying frenzy. The rumors have started to fly: “The Duke Brothers (with Beeks as their agent) are looking to corner the market!”

FCOJ prices are now on a tear, rising as high as $1.45 per pound. Until now, Winthorpe and Valentine have been lying in the weeds and with perfect timing begin to scream “Sell, sell, sell!” right at the top of the market. The true crop report numbers are then revealed, and the market begins to crash and, once again, at the optimal low point of 29¢ per pound, our boys reverse course and start screaming “Buy, buy, buy!” They are now covering their short sales. The majority of these sales were made—well above $1 per pound, so they are covering from 25¢ to 46¢ and netting millions in the process. The Dukes, having bought near the top, are left holding the bag.

The classic 1983 comedy Trading Places is one of my all-time favorites. Winthorpe is beautifully portrayed by Dan Aykroyd as a rich commodity broker turned homeless, with Valentine played by the comic genius Eddie Murphy as a homeless man transformed into a rich commodity broker. Many people believe that the story was inspired by the silver market’s incredible rise and ultimate fall in 1980 when the Hunt brothers of Texas tried unsuccessfully to corner that market. Silver prices crashed in March of that year when the brothers were unable to meet their last $100 million margin call.

The unsung star of Trading Places was the trading pit itself—the actual pit at the New York Board of Trade (NYBOT) where real traders played themselves in the movie. The climactic scene (in most viewers’ minds) is the chaotic buying frenzy that took place in the pit (although some male viewers might argue the climactic scene was when Jamie Lee Curtis took her sweater off). In any case, the movie would not have been as visually exciting or nearly as suspenseful without the trading pit. It’s hard to imagine any excitement if our heroes were just clicking a mouse in front of a computer screen.

Trading Places is now more than 25 years old. The NYBOT—the exchange where coffee, cocoa, sugar, and, yes, FCOJ is traded—was established in 1870. Here comes the sad part: On December 13, 2007, the NYBOT board of directors voted unanimously to permanently close the trading floor, moving 100% of the commodities trading to the computer screen. Open-outcry trading, the backbone of the Exchange for more than 100 years, was permanently silenced in February 2008. It was progress, but the pit closing put 1,000 traders and support staff out of work. One veteran pit trader told a New York Post reporter, “Most of these people really don’t know how to do anything else, and now we will all have to find our place in the world.” However, other than these folks, the closing had little to no effect on the dealings in these key global commodities. That’s because more than 90% of the volume had already moved to the computer screen by this time. In the rest of the world, electronic trading for commodities had been the norm for years. Although small pockets of pit traders remain in certain commodities, the writing’s on the wall. The computer will ultimately totally eliminate the pit trader. Why? Pure economics—it’s cheaper. No need for traders to leave their homes in the morning. No need to maintain a downtown facility with the associated high rents and utility costs. No need to hire runners, phone clerks, and trading clerks. And above all, no need for the pit trader. I used to pay a good pit trader an extra $2–$5 per contract (above normal clearing fees) to execute my trades, and I was glad to do so. If the guy was louder or bigger or quicker than my competitor’s floor broker, I would often get the better price.

The cost savings of computerized trading is obvious, but another advantage emerges: a level playing field. Ernest Hemingway once said, “The best way to find out if you can trust somebody is to trust them.” In the olden days, you really had to trust your pit broker. Let me share a true story with you. Years ago, I was using a floor broker in the New York silver pit to execute my trades there. All was going well until one day I placed an order to buy 50 silver contracts at a price that should have been easily filled. After some time had elapsed, the market surged higher, netting me a tidy profit—or, at least, that’s what I thought. I had been waiting for the pit broker’s phone clerk to call me back with the fill. He hadn’t called yet, so I called the floor. The broker got on the phone and denied I had ever placed the order. To this day, I have little doubt that he filled the order and pocketed my profit for himself. Because the phone call wasn’t recorded at that time, my only recourse was to never use this guy again, and subsequently I did find a pit broker I could trust. This kind of problem doesn’t occur with electronic trading—the computer can’t lie.

Other than the substantial cost savings of eliminating people, electronic trading offers additional benefits. You can place orders faster, as fast as a mouse click. During a fast-moving market in the olden days, it was entirely possible to miss our price by the time the runner delivered our order to the pit broker. Even with using a market order (required to be filled at the next available price) during a wild pit session, we might not have known for hours what price we were filled at. In erratic market conditions, a good fill was often the luck of the draw. Today these doubts are gone—fills return to the trader instantaneously. The computer can also manage multiple orders and price fills more efficiently than a human. Clearing firms like computerized trading as well because credit and risk management is automated. The computer can cut off an out-of-control trader before the trader’s account ever moves into an unsecured debit position.

Reduced cost, speed, enhanced information management, the expansion of markets globally with 24-hour trading...isn’t technology terrific? Other than the loss of a few jobs and the romanticism of the bygone era of the pits, are there any downsides?

The legendary trader Jesse Livermore once said something to the effect that technology might change, but the markets never will because markets are made by human beings and human nature doesn’t change. Traders today still make the same mistakes made by traders 50 or 100 years ago. This is true. Markets will continue to trend up and trend down.

“The trend is your friend” was a basic theme of my previous books. This truism has not changed and will remain a primary theme for successful trading in this book. I can cite literally thousands of examples of markets that have trended long and far and, in the process, made some people rich and wiped out many others. You might have heard about the poor soul who lost his farm. I can almost guarantee that guy was bull-headed and fought the prevailing trend of the market until he finally ran out of money.

In the 1920s, the New Haven railroad was the premier blue-chip stock of the day and sold as high as $279 per share. In those days, you could trade stocks on 5% margin as we trade futures today. When New Haven sold 50 points off the top, it must have looked cheap at the time. How many would have had the guts to sell it short when it crossed below 179, 100 points from the top? Better yet, who would have had the guts, or the vision, to sell this investment-grade security short at 79, or 200 points from the top? It must have looked extremely cheap at 79—remember, this was the Apple or GE of its day. Yet the trend was down, and after the crash of 1929, it traded as low as 12. In 2000, a friend of mine bought a “new technology” stock at the offering price of $66. He added to his position at $150 a share, again at $200, and then again at $300. I suggested he use stops to lock in his profit, but he “knew” this company was only going up (his daughter worked there), and he told me it would ultimately trade at $1,000. It did keep going up beyond what I imagined it ever could, and he added to his position at $450 and $500. It actually traded as high as $600. Today it has ceased trading, going off the board at $0.

Remember Enron? This was a “blue-chip” energy company and the largest contributor to the 2000 Bush presidential campaign. At that time, the stock was trading at $90 a share. Today it no longer exists. If you still own the stock, you can use your certificate as wallpaper. The trend is your friend—do not fight it. Electronic trading will not eliminate trends or eliminate future Enrons or silver crashes. The keys to successful trading are still, and always will be, successfully identifying the trend and practicing good money management, combined with the essential qualities of patience and discipline.

I have long subscribed to Livermore’s belief that markets do not change because human nature does not change. In many ways, this is a truism, but not in one major way. Eliminating people from the middle of the equation has made a big difference. Electronic trading has changed the markets—hence the reason for this book. As a trader, I’ve had to adjust to new market realities. And if you trade commodities, you absolutely will need to adjust your methods as well. One of the objectives of this book is to help guide you through these uncharted waters.

What are the consequences of eliminating people? The answer, in one word, is volatility. As a result, new trading skills are required for success. Speed and volume have combined to make the markets more volatile. Volatility can lead to trader anxiety; however, an anxious trader will not be a successful trader. Succeeding in trading today requires the ability to cope with exploding volatility. Think I exaggerate here? At times the markets have always been volatile, right?

Are you old enough to remember the good old days when gasoline was less than $1 a gallon? Consider Chart 1.1.

Chart 1.1

Chart 1.1 Crude oil 1994–1995

Source: CQG, Inc. © 2008 All rights reserved worldwide.

This is a daily chart of the oil market for the 1994–1995 trading period. Each vertical line represents one full day of trading. You are looking at nearly one full year of oil futures trading. The chart appears to illustrate a volatile market with big ups and downs throughout this period. However, it all depends on how the chart is scaled.

The price range during this ten-month period was an extreme high of $19.07 per barrel in August, with an extreme low of $17 in December. This is a $2.07-per-barrel range from high to low within this entire period. The size of one oil futures contract is 1,000 barrels; therefore, every $1-per-barrel move equals $1,000 profit or loss per contract traded. During this 12-month period, we saw approximately a $2,000-per-contract range in price movement between the two extremes—not an atypical year for that period.

Today the oil contract size is exactly the same; however, volatility has exploded. Consider this recent example in Chart 1.2.

Chart 1.2

Chart 1.2 Two days of oil trading

Source: CQG, Inc. © 2008 All rights reserved worldwide.

You’re now looking at a 30-minute chart of the oil market that covers just two days in August 2008. Each vertical line represents 30 minutes of trading (versus one day per line in the previous chart). During the first highlighted one-hour period (two 30-minute bars), the price ranged from $122.30 per barrel to $126.03 per barrel, and in just one additional 30-minute period (from 8:30 a.m. to 9:30 a.m. CST), oil ran up an additional $2.57. Within just this 1 1/2-hour period, the range was $6.30, or $6,300 per contract traded. In only 90 minutes this day, the price range was triple of the entire 1994–1995 trading year. The next day, a similar dollar move in the exact opposite direction occurred. This is not atypical for the current market environment.

How about this? Chart 1.3 is a one-minute chart of the soybean market. Each vertical bar represents one minute of trading.

Chart 1.3

Chart 1.3 One-minute soybean chart

Source: CQG, Inc. © 2008 All rights reserved worldwide.

Seemingly out of nowhere in a quiet market, the beans collapsed 50¢ a bushel and then immediately recovered, all in less than one minute. This is equivalent to a $2,500 move per contract down and back up in less than a minute. Today, action such as this is unfortunately (or fortunately) quite common.

Why this dramatic rise in volatility? Screen trading is the major culprit; however, reasons other than electronic trading are to blame, too. Commodity demand has multiplied in recent years due to the dramatic industrial revolution in a number of countries, notably China. This demand increase (with a dose of inflation) has resulted in higher prices. Higher prices lead to larger ranges for the same percentage moves. For $19 oil, a 10% move equals $1.90, but for $90 oil, a 10% move equals $9. So this is part of it, but it doesn’t fully explain the velocity and ferocity of today’s market movements (let alone the volatility).

Remember the old days when you heard a song on the radio and wanted to buy the album? The process involved physically going to the record store, finding what you were looking for, and returning home to play it. This process took time. Now you can find and download music in seconds over the Internet.

The main reason for the increased speed of market movements is the Internet—a direct result of the dramatic shift during the past few years away from nearly 100% pit trading to nearly 100% electronic trading.

Until recently, this is the way I would place an order in the commodity markets: I would pick up the phone and dial a trading floor. Hopefully, the clerk would pick up the phone call in a timely manner, but in a fast-moving market, sometimes it would ring forever, and this could be maddening. When the clerk did pick up the call, I would read my order, and the clerk would write it on an order ticket and then time-stamp the ticket. Good procedure required the clerk to read back my order to me for confirmation and consistency before he or she sent it off. The clerk would then pass my order to a runner (hopefully the runner was near the phone clerk and not out having a cigarette), who then physically walked it to my broker in the trading pit (or, at times, the broker’s clerk adjacent to him in the pit). The pit broker would cue the order, and when the market approached my price, he or she would yell out the buy or sell into the trading pit, looking for an offsetting trade via the open-outcry process. After it was filled, the process would reverse from runner to clerk, with more time stamps, and eventually it would be phoned back to me. This all took time. Looking back, it is amazing we operated this way, in most cases efficiently, for the bulk of my trading career.

Now with electronic trading, orders are disseminated and received instantly over the Internet. Orders of all sizes from around the globe are now entered instantly with a mouse click, eliminating this entire human-based process.

This volatility enables many opportunities, but it also increases the risk geometrically compared to the old days. So how does a trader cope with this rise in volatility? The answer lies in computing power. We used to keep charts by hand, but now the computer draws the charts for us. A computer also calculates those same market studies in real time that we used to do at night by hand after the market closed.

As an example, in Chart 1.4, I’ve reproduced the 30-minute oil chart and superimposed a 60-period simple moving average. By monitoring where the market is in relation to this average (particularly on a close for each period), the computer can help a trader identify the true internal trend of a market. Today a trader needs to compress his time parameters and use computing power over shorter time spans. The computer cannot eliminate the volatility and speed of today’s markets—these factors are here to stay. But computing power in today’s market environment is a necessity to analyze the markets at a speed the human brain is incapable of doing.

Chart 1.4

Chart 1.4 Thirty-minute chart (with moving average)

Source: CQG, Inc. © 2008 All rights reserved worldwide.

The bottom line of the market change is that electronics speed up the process, resulting in greater volatility. This means that, as traders, we also need to change and use technology while maintaining those time-tested methods that work.

The objective of this book is to meld the necessary adjustments for the current market environment while maintaining those timeless methodologies that have worked in the past and will continue to work in the future because of human nature. Fear and greed ultimately move markets. And no matter what machines we utilize, these human traits will never go away. Speed can be our friend or our enemy. As the legendary trader W. D. Gann once wrote, “Most people are in too big a hurry to get rich and as a result they go broke.”

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