Real work in trading
Hello, I am a 3rd year student in finance.
I don't understand exactly what a trader does on a day to day basis
If an institutional wants 1,000 A shares, we take the institutional's money and buy those 1,000 shares and that's it, why do we talk about "managing risk"?
I know that the job of a trader in an investment bank is not only to execute but I don't understand exactly the mechanism.
Thanks on advance
I have worked on the space's sell and prop trading sides and am happy to explain the mechanism/workflow here. I have also traded both spot/delta one products. Here is the workflow, and once you read this, it should be easier to understand.
Typical Sell-Side Workflow (SPOT):
AAPL trades at $150
Hedge Fund A comes in and asks for 10,000 shares of AAPL
I provide a two-way quote in which I am happy to buy or sell 10,000 shares of AAPL to the client. Example, 149-151
Hedge Fund A buys or sells based on the bid-ask spread I've provided
Once they buy/sell from me, I must go to the market and hedge the risk. If they bought 10,000 shares from me. I am short and need to go to the market to buy the 10,000 shares to stay flat. If they sell 10,000 shares to me, I need to go to the market to sell them to remain flat.
Let's think about the above scenario. First, there typically will be an agency fee where I make money through their trading. Let's say 0.01c a share or something or like a 10 bp execution fee on the entire order. If they buy from me and I'm short 10,000 shares of AAPL, maybe the desk decides hey - let's not fully hedge this position and run 5,000 shares short. If AAPL ends up going down, we make money here. If it goes up, we lose money. Now, let's think about the hedging position. If they sold all 10,000 shares to me at 149 (my bid), and I can sell them in the market for an average price of 149.7, then I make 149.7-149 * 10,000 P/L from the hedge.
Three ways to make money here. Agency Fee, Hedging, or Prop Position bet. The desks that allow you to take on the most prop positions are typically the candidates who leave S&T to become PMs at hedge funds. If you're consistently getting prop trading bets on the market correct and making money from your ideas and execution, then this is a valuable skillset, right?
Typical Sell-Side Workflow (Derivatives):
AAPL 150 Weeklies trade at 1.00
Similar workflow to above:
Hedge Fund A wants to buy 10,000 AAPL 150 Weeklies
Sell-Side Traders provides a price lets say 0.92 - 1.08
Hedge Fund A buys or sells based on the bid-ask provided
Sell-Side Trader hedges the risk or assesses the position. The difference is with options; there are SEVERAL new factors to consider when managing risk other than direction. Theta/Time-To-Expiry, Vega/IV, Delta/Direction of the Market, Gamma/Speed of the Market, etc. Most sell-side traders buy or sell the options at this point and are executing delta hedges simultaneously, so they're only exposed to the three other Greeks that aren't delta.
If they don't like the new risk, I.e., HF sells me a ton of ATM weeklies (very high Gamma exposure). I may think the market isn't going to have many massive moves here, I'm bleeding theta, and the P/L from delta hedging and monetizing that gamma isn't going to outweigh the cost of theta I pay from all the options I bought from that HF. In this scenario, maybe I sell some in the OTC markets or start backing out of them on screens. If a hedge fund sells me 3-6 month ATM options and I'm burdened with tons of $Vega, I need to consider this. What if another client comes in and buys some 25 delta 3-6 month options from me? It will reduce my Vega but give me exposure to a new risk - Skew/Smile risk. Lots of things to consider. What if implied volatility increases here? Well, I need to now think about the delta of my OTM options. Delta of OTM options increases as IV increases while ATM stays relatively stable - this will impact my delta hedge, my Greeks (Vega of OTM options increases while ATM stays the same in this scenario) and how I need to think about the markets.
I think this is why vol/derivative traders are typically the ones who become PMs at pods/MMs/macro funds. There are several ways to make money in a scenario like this. People who are consistently right about timing the market, correct about the market's volatility, correct about the speed of the market moves, etc., have a valuable skillset.
With options trading, it's really difficult not to be exposed to some level of risk, so most options desks always need to have some prop view unless they can completely exit their option position and profit from the spread.
The simplest difference between prop/sell-side is that prop firms are most likely taking more bets on greeks/direction rather than trying to back out of the flow/warehouse risk. This means some sell-side desks that end up having illiquid products and require some risk warehousing can be very similar to prop trading desks. There's more about this, but it should be a good summary.
TLDR: Sell-side is given the opposite positions of buy-side traders and have the ability to make P/L through bets on that position (I like the $Vega the fund sold to me), agency fees (I charged ten bps to execute the trade), or through the hedging in the open market (I fully closed the position on the open market for a tighter spread than I quoted the client).
Thanks for all of the bananas, feel free to ask any questions and happy to respond via DM or here.
Hhhh
Great answer and thanks for sharing.
When we are short the 5000 shares to profit off a directional move - how long do you have until you have to close out this short? Intraday?
This would depend on the team. To be transparent, I started trading in 2020 on the sell-side for a crypto-native firm before transitioning to the prop-side of a TradFi shop on a crypto options team. For us, it was as long as we wanted. If we thought BTC or ETH were trending up, we'd be happy to carry residual deltas on our option positions, and we'd be happy to buy BTC/ETH for lower than the offer and hold anywhere for an hour to a few days.
Someone who trades equities at a bank can chime in on holding periods for their desk. Crypto trades 24/7, and the gap-risk of BTC/ETH is much lower if almost none, compared to the equities markets, which close at a certain time and then open back with pre-market liquidity where most trades go through dark pools or OTC anyways.
TLDR: Many factors go into timing - the risk appetite of your team, the risk appetite of your firm, and the asset class you're trading/liquidity bounds (I don't wanna be holding a bag when I can't get out of it)
Okay, thank you very much, I see more clearly. I really appreciate your answer, thank you very much.
But this seems to act like a market maker, right? A trader is a market maker or am I wrong?
A market maker gets paid with the spread and commission I guess but the trader has the risk part to manage on top of that, right?
I think the idea of "how the trader gets paid" is fine, I understand that part very well.
But how does this part work
"AAPL is trading at $150.
Hedge fund A comes in and asks for 10,000 shares of AAPL.
I provide a two-way quote in which I am happy to buy or sell 10,000 shares of AAPL to the client.
Example: 149-151
Hedge fund A buys or sells based on the bid/ask spread I provided.
Once he buys/sells from me, I have to go into the market and hedge the risk. "
Do you go directly to the market?
Like
* HF wants 1000 shares
* You provide a quote
* They agree to pay
* You deliver those shares from your account (You don't go to the market? That's with all the securities your investment bank holds?)
* They receive your securities
* You hedge in the market (over/under hedge, that's your strategy).
I don't know if this is a stupid question but I need to go into detail to understand the situations...
So to conclude, in IB traders can make profits by managing risk and what about the Volcker Act? This law restricts traders in what way?
Thanks for your time and knowledge
Yes happy to explain. It's very hard to explain this to someone who isn't in the industry, but when people describe firms like SIG or Akuna or DRW, you're probably thinking oh, those are prop trading firms. In reality, market-making is the bread and butter for these firms, in my experience. Market makers get paid through spreads and commissions, as you say, but depending on the propensity toward risk the firm's culture has, maybe they wait a while to close out the other end of the trade or wait a while to hedge it.
I am at Akuna/DRW-type shop, and we carry residual deltas after trading options. We make a market for institutions or on-screen and accumulate positions inside the bid-ask spread. I.e., We are buying on the bid instead of the ask by leaving resting orders there (market making) and selling on the ask instead of the bid by the same mechanisms. When we do that, we inherently make a theo p/l because we're buying below the mid and selling above the mid.
Some traders at a firm like Optiver/Akuna/DRW have automated systems quoting live markets on screens and slowly accumulating positions. Some traders only face institutions and make markets on massive blocks. Both types of traders need to manage the risk after they get their positions.
For the first question: TLDR - Market Making is a core strategy of most Prop Trading firms, and typically from my experience, one of the only strategies at a bank on the institutional S&T desks. In S&T most of the work I was doing along with my team was automating things for our desk to make our lives easier; we were not researching taker strategies to put on with the banks capital. In prop trading, most of the coding is analyzing volatility regimes and figuring out ways to manage or even take risk more efficiently.
It's hard to explain because there's so many different firms, and trader/quant can be an all-encompassing title. What I am describing here can completely differ from a firm like HRT or Tower Research. I work at an options market maker (Akuna/DRW/SIG) on their crypto team. I might also be off how I am describing the sell-side, this is just my anecdotal experience on my desk.
EDIT: Also, all of these prop firms usually have institutional desks that do exactly what banks do as well lol. Like I said your responsibilities as trader at a bank on a specific team might actually be very close to what you'd do at a prop shop, just depends on the product, the team, and the culture. DRW has institutional traders, same with Flow Traders, same with Optiver, same with SIG.
Part 2 Question: Do you go directly to the market? It depends here. If you're holding inventory, maybe you're happy to offload some; if not, you need to pick up those shares for settlement. I work in crypto, not equities or FICC. When an HF wants to buy 10M BTC, I might be holding $5M worth and need to go across separate venues and algorithmically execute the other $5M to deliver to them to settle.
Maybe a counterparty at a bank on the sell-side can opine here, but at my firm we never needed INSTANT settlement/delivery, there's always the back office teams and operational things that need to happen. They don't really NEED to receive it immediately right. The hedge fund trusts Goldman isn't going to fuck them, so as long as the trade confirms are sent and they see that you sold them 1M shares of AAPL at 151, they aren't going to think you ran off if it takes an hour or two to settle (ONCE AGAIN I HAVE NO IDEA FOR EQUITIES).
In my experience, when Brevan Howard Digital buys $10M of BTC from us, we can pretty easily get that in the market in a few minutes, or they might ask us to run a programmatic execution for them, like a $100M TWAP (when I was on the sell-side). Then it takes a few minutes and I'm pretty siloed from operations so idk how long it takes to deliver, unfortunately.
To conclude: I have zero idea how Volcker act impacts traders because at the end of the day these desks at banks are still warehousing risk and can "pre-hedge" etc. We would need someone at a bank to explain further how that impacts them/their team. When I was on a sell-side desk in crypto, we were not impacted by Volcker ofc because it's for banks, and then when I moved to prop, it's prop so we don't care about Volcker.
How common is S&T to MM HF? I was under the impression that most came from IB/ER, or is this at a different seniority level?
Obviously a MM HF isn’t going to hire someone from IB or Equity research to trade Fx options or interest rate swaps or equity index volatility arbitrage. Long-short equity is for bankers and the macro pods are for S&t
In your first scenario (SPOT), does the team maintain a 10,000 share balance of AAPL at all times? Is that why when a client buys 10,000 you may decide to go to the market and buy back 10,000 shares?
When the client buys 10,000 shares and you are short and you decide to go to the market to buy 5,000 then AAPL price goes down, how do you make money?
Does short here mean you have 10,000 shares less, or “short position” on the stock?
I’m guessing it’s the latter, and you buy shares again to maintain inventory, returning to the balance of 10,000 shares but now at a lower price than when you sold to the client. Can you confirm? Thanks
Why don't HFs have in-house trading teams to do this for them (and save on transaction fees)?
They don't want to register as broker-dealers
Thank you. How long does it take to hit to hit the desk/manage flow (if that is even correct to say) after starting on the job? Curious on the timeline of the process going from learning theory to actually managing risk. Are there any resources that you would recommend for learning the theory and then practices for learning risk management/execution component? Or is the latter a purely learn-on-the-job component
Just my 2 cents! Think there's no hard and fast rule here, and would boil down to - and this list by no means extensive - (1) sell/buy side, (2) which shop you're at, (3) product/desk, (4) EQ/IQ and lastly (5) a smidge of luck/opportunity.
To elaborate:
(1) Juniors on buy-side especially in discretionary shops tend to gravitate towards a model where in hokkien can be succinctly labeled as 'bao ga liao' which translated means "Doing everything, covering all roles". If your PM or head-of-trading trusts you, you might get a small book to manage or some risk to handle rather than just being an execution monkey. On the other hand, junior traders on the sell-side tend to have to go through their own firms' rite-of-passage before being given any opportunity to handle risk, and this process could be anywhere from 6months to 6 years [further elaborated in (3)].
(2) How quickly you get to manage various amounts of risk would really depend on how much flow the firm is receiving and whether you're trustworthy enough to manage that risk. More neutral MMs that see buckets of flow and generally more lax about letting juniors start to handle small amounts of risk early on since mistakes are easier to cover with just axing out their risk through their flows - then this begs the question of each firms' specialty of flow and product [further explained in (3)]. On the other hand, firms/desks that take more prop-risk are less inclined to give juniors' risk because you're just a baby and have yet to absorb copious amounts of information and have not developed a "feel" for the mkt, once again delaying your timeline to "take risk"
(3) A large part of whether you get risk and how much you get boils down on the nature of the desk and complexity of product. For example sitting as a sales trader on a equities desk or delta-1 desk might get you on a fast-track to handling risk since the reality is that you may not be required to hold inventory and getting rid of unfavorable positions would be easier. This is in contrast to say an FXO/IRO desk where risks are non-linear and multifold - no shop is going to trust a junior with 1/2 years of experience to start pricing and quoting for brokers. On these desks, it could be 5 year grind before one gets his own 'small book' or 1/2 ccys to quote and manage.
(4) IQ and EQ are such an integral part of any job and your ability - especially that of a trader - to be perfect in the small details is crucial. Ask questions, learn and don't make mistakes. Don’t be sloppy. This is the worst possible trait for a junior trader. Be precise when describing your position, book trades properly the first time, and be able to explain your P&L and position accurately at all times. Network with seniors, MDs and brokers - it's a relationship driven world and being 'good' at your job isn't going to cut it if you want to start contributing to your desk's budget.
(5) Truth is traders are one of the most expensive costs to any firm. As a trading business, hiring you to manage risk/trade has a negative expected value off the bat; i'm obligated to pay you salary and some form of PnL related bonus - with no guarantee you're going to be a profitable trader and make money for me. Sounds like a horrible deal but I don't have a choice and generally if I hire well and you're a profitable trader, we both win. But these now exclusive seats are limited and not any tomdickharry can come off the streets and get a chance - what's your historical sharpe? what franchise/clientele might you bring with you? what broker relationships have you built that might give you an edge? Chances are, as a junior, you're going to have to wait for someone above you who's been keeping the seat warm to get a better deal elsewhere or get fired before you get a shot at that role, and by extension a chance at taking risk. So when you do, don't mess it up, you're only as good as your last trade.
Happy trading folks!
Hey I saw your post and was wondering if you knew anything about how it differs from algo trading? I am interning in electronic s&t and am familiar with concept of dark pools but was wondering how traditional s&t differs from algo trading.
Guy above did a good job of explaining from the perspective of equities - the process is essentially similar for rates and fx.
If I sell a treasury bond to a market maker, they can choose to:
1. Immediately sell the bond to someone else for a higher price (unlikely)
2. Sell another similar bond to someone else or the same counterparty (bond switch)
3. Hedge by selling bond futures with a similar maturity as the bond
4. Hedge by paying fixed on an interest rate swap with the same maturity as the bond
In reality, they would probably do 3 or 4 and hold the position (if they're comfortable with the basis or asset swap risk) or do 3 or 4 to hedge X% of the delta (exposure to rate moves up/down) depending on their view of rates while they attempt to do 1 or 2 and then unwind the hedges.
Sell side traders make money two ways:
1. Taking bid-offer (selling higher than mid and buying lower than mid, inclusive of hedges)
2. Prop/directional risk (this is where the X% hedge ratio comes in)
If an institutional wants 1,000 a share, we take the institutional's money and buy those 1,000 shares and that's it, why do we talk about "managing risk"?
here is your first doubt cleared!!!
We talk about "managing risk" because it is crucial to ensure the preservation and growth of investments while minimizing potential losses. When investing in financial markets, there are inherent uncertainties and potential negative outcomes. Managing risk involves identifying and assessing these risks, implementing strategies to mitigate them, and making informed decisions to protect investments.
Taking the example you mentioned, if an institutional investor wants to purchase 1,000 A shares, managing risk would involve considering various factors. This could include evaluating the market conditions, analyzing the company's financial health, assessing the potential risks associated with the investment, and determining an appropriate entry and exit strategy.
By managing risk, investors aim to protect their capital, achieve favorable returns, and avoid excessive exposure to potential losses. It is a proactive approach that involves understanding and navigating the uncertainties and fluctuations of the financial markets to achieve long-term investment objectives.
I know that the job of a trader in an investment bank is not only to execute but I don't understand exactly the mechanism.
here is your second doubt cleared!!!
The investment banking mechanism involves several steps to facilitate various financial transactions. Here is a step-by-step explanation of the investment banking process using an initial public offering (IPO) as an example:
1. Company Decision: A private company decides to raise capital by going public and offers its shares to the public through an IPO. They typically hire an investment bank to manage the process.
2. Due Diligence: The investment bank conducts extensive due diligence on the company. This involves analyzing the company's financials, operations, market potential, and risks to determine its valuation and attractiveness to investors.
3. Valuation and Pricing: Based on the due diligence, the investment bank determines the fair value of the company and sets the IPO price. They consider market conditions, comparable companies, industry trends, and demand-supply dynamics to arrive at an appropriate valuation.
4. SEC Registration: The investment bank assists the company in preparing the necessary documentation and filing with the Securities and Exchange Commission (SEC) to comply with regulatory requirements for the IPO.
5. Underwriting: The investment bank underwrites the IPO, which involves guaranteeing the sale of a certain number of shares at the IPO price. They take on the risk of purchasing the shares from the company and reselling them to investors.
6. Marketing and Roadshow: The investment bank markets the IPO to potential investors through a roadshow, where company management presents the investment opportunity to institutional investors, analysts, and fund managers. They generate interest and gauge demand for the offering.
7. Book Building: During the marketing process, the investment bank collects indications of interest from investors and builds an order book. This helps determine the final allocation of shares and the IPO price.
8. Allocation and Pricing: Based on the demand and investor interest, the investment bank determines the final allocation of shares and the IPO price. This information is shared with the company and investors.
9. Listing: Once the IPO is priced, the investment bank coordinates the listing of the company's shares on a stock exchange. The shares become publicly tradable, and the company raises the desired capital.
10. Post-IPO Support: After the IPO, the investment bank may provide support in market-making, liquidity provision, and ongoing investor relations activities to ensure a smooth transition for the company as a public entity.
It's important to note that the investment banking process can vary depending on the specific transaction and market conditions. The steps outlined above provide a general overview of how an investment bank typically manages an IPO.
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