Trade Execution

S&T: An Insider’s View

I stumbled into a Wall Street Trading floor having no idea what a Wall Street Trader actually does. I struggled to find any good information online or in books. I signed up for a trading competition that JPMorgan was hosting. With mostly luck (and maybe some skill), I was a finalist and won an all-expense paid trip to New York to see an actual trading floor.

I arrived as dopey college junior who had no idea what a trader did, or any of the details of what asset classes the bank traded. I had a 30 minute meeting with the head of Rates and FX trading at the time. He used to be a big shot trader at a $100 billion dollar hedge fund.

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I had no clue how trading works, and it was instantly apparent. I didn’t get a job offer that day, but somehow got lucky twice and ended up back at JPMorgan as a full-time analyst. I spent the next 10 years learning the ins and outs of the trading floor. I redeemed my lack of trading knowledge and I ended up working for that big shot trader (he was my bosses’ boss).  Don’t make the same mistake I did, and in this article I’m going to give you an insiders view of how Trading on Wall Street actually works.

Here’s the ad in the college newspaper for the trading competition that started it all.

Types of Trading on Wall Street

There are four main types of trading. Most of the traders currently on Wall Street are Flow Traders.

1. Prop Trading
2. Flow Trading
3. Agency Trading
4. Electronic Trading

Prop trading doesn’t involve clients, it’s like working at the bank’s internal hedge fund. All the other roles are client facing. How a client trades depends on the underlying asset class. For example, if I was a Hedge Fund client and I wanted to trade Tesla with an Investment Bank, how its traded depends if it wanted to trade the stock or the bond. Tesla stock trades on an exchange and that would be Agency Trading. The Investment Bank doesn’t take risk, they take my order, pass it to the exchange and collects commissions. Tesla Bonds don’t trade on an exchange and that would be flow trading. Instead of trading taking place at the exchange, and having an exchange match buyers and sellers, trading takes place with the Investment Bank’s trader. The trader set prices they will buy and sell the bond and manages the risk. In either case the Agency or Flow trading case, if I as the Hedge Fund used the Investment Bank’s electronic platform to send in the trade, that’s Electronic Trading. We’ll go through examples that put it all in more detail.

What is Prop Trading?

The Fantasy Futures trading simulation I did was basically prop trading. I was given prices of bond futures in three currencies that i could go long or go short. I was trading versus the computer or “simulation market” and didn’t trade with any real or pretend clients.

Banks used to have separate trading groups called proprietary trading or prop trading for short. These traders were a separate group from Flow or Agency Traders and operated like the Investment Bank’s own hedge fund. Prop traders choose which trades they liked and held onto their investments, just like an investor. Their capital was from the bank’s own capital and Prop Traders needed to generate returns just like a regular hedge fund.

Prop Trading attracted the best and brightest traders. Flow trading was a proving ground and the best traders were recruited to the prop desk. It was also a great way to retain talent that may have left for hedge funds.

Prop trading is now mostly gone from Investment Banks. Regulatory changes, and in particularly the Volker Rule, forced banks to stop prop trading. Most banks spun out their prop trading desks and turned them to independent Hedge Funds.

What is Flow Trading?

Flow trading is where the bank acts as Principal. The client decides if they want to buy or sell, and the trader sets the price and takes the other side.

Think about buying a car. If I wanted to sell my Ford Mustang, I would take it to a dealer and the dealer would tell me what price they would buy it at. I could compare prices by taking my Ford Mustang to different dealers and choosing the dealer that gives me the best price. If I wanted to buy a new Ford Mustang, I can’t go to the factory, I would have to go to my local Ford dealers, see what they have in Inventory and compare prices. If they didn’t have the color, style or transmission I wanted, I could ask them to order one for me either from the factory or have them buy it from me from another dealer.

Flow traders make money by charging a bid-offer spread on a high volume of trades

Flow trading corporate bonds work in the exact same way. They trade over-the-counter, meaning not on an exchange.  The Investment Banks are the analogous to the car dealers, and buy and sell bonds based on which bond the Investor chooses, and the Investment Bank’s Flow Trader sets prices for where they buy and sell bonds.

Flow traders make money through a high volume of transactions and charging a bid-offer spread on each transaction. A bid-offer spread involves making markets in a stock, bond, or a derivative, with the trader buying at a lower price (bid price) than they are selling it (ask price).

Example of How a Real Trade is Executed on Wall Street

Imagine you’re a trader at Goldman Sachs and Fidelity (a big asset manager) calls you asking to sell a Tesla bond.

Your market on the bond is 90/92 – meaning you are willing to buy the bond at a price of $90 (your bid price), and sell the bond at $92 (your offer price). The slash “/” separates your bid price from your offer price. These prices are quoted from the trader’s point of view. Fidelity Sells, You (Trader, GS) Buys.

These dollar prices are really percentages. A price of $90 means you’ll pay $90 for each $100 Tesla is scheduled to pay in 2025 (this particular bond’s maturity), or 90%. This price is based on the market’s current view of the credit, risk and maturity profile of the bond.  For example, if Tesla announced weak financial results, and market participants thought there was a higher risk that Tesla might go bankrupt you’d expect the price to drop further.

As the trader, your job is to make markets. You won’t have time to have a detailed view on each bond you as assigned to trade. When Fidelity calls and wants to either buy or sell, your job is to quote price where you are willing to buy or sell. You’re a trader at Goldman Sachs, and you’re not a charity. You charge the clients a bid/offer spread to provide this service.

If Fidelity had a large client redeem funds from their High Yield Bond fund, they may need to sell some bonds. You would buy the Tesla Bond from them at $90. Right after we said done and agreed on the trade, if Fidelity received new client funds from another client and needed to buy more bonds, the price for Fidelity to buy that same bond back isn’t $90, it would be at your offer at $92. You would make $2 on each $100 of bonds that you bought and sold.

In our example, once Fidelity decides to sell, they “hit your bid” and sells the bond to you at the price of $90 that you quoted. To confirm the trade, I send a trade ticket from Bloomberg. All the traders, salespeople and investors use Bloomberg. Here is an example of what the confirmation ticket or VCON looks like.

Now, you own the bond, what do you do? You haven’t read through Tesla’s Financial Statements or Built a Financial Statement Model that you would do if you were an Investment Banker or the Credit Analyst at Fidelity.

You need to act quickly. You could lose a lot of money if there was negative news on Tesla and the price of the bond fell. I knew of a trader that owned American Airlines Bonds before American Airlines declared bankruptcy, she lost her job shortly afterwards. What you would do for Tesla is hedge the position. You can hedge the credit risk of Tesla using a credit default swap (CDS) and you can hedge the interest rate risk with the rates desk.

After you hedged your position you can breathe a little bit easier. Now you try to find a buyer for the bonds. You can tell your salespeople that you want to, or in market speak “axed” to sell the bond.  One of your salespersons might have arranged a call between BlackRock (another Asset Manager) and Credit Research. If the BlackRock portfolio manager liked the name, they might be inclined to buy the bond.

The day to day job of a trader goes beyond quoting prices, you want to capture trade flows, maximize your bid-offer spread and limit your market risk.

The salesperson makes the call, and success, they want to buy the Tesla bonds you bought from Fidelity. You sell the entire position to BlackRock at a price of $92 and you (Goldman Sachs) make $2 for each bond. You sell the bond and sell your ticket. You also unwind your hedges, you no longer need to pay for your credit default swap or your interest rate hedges. The traders for the hedges do charge you a bid/offer spread as well, but less than the spread on the underlying bonds. The bid/offer on your hedges is $0.50 cents in this example, so your net profit after factoring in your hedge costs is $2.00 – $0.50 = $1.50

As a flow trader, your job isn’t to have strong views on whether a particular stock or bond is a good long term buy. Your job is to facilitate trades from buyers and sellers and profit from the bid offer spread. The buyer and sellers choose the timing and which bank to trade with. You can capture more of the trading flow, making sure more of the trades go through you versus a competing bank by showing a competitive price and bid-offer spread. Your role is to capture the trading flow, make the bid offer spread and limit your market risk.

The day to day job of a trader goes beyond quoting prices, but somedays it can feel that’s all you do. You need to highlight ideas and opportunities to institutional investors and encourage trading flows.

What is Agency Trading?

Cash Equities, Futures and Equity Options are typically Agency traded. Stocks (cash equities), futures and Equity options are listed and traded on an exchange (NASDAQ, NYSE, CME) with limited exceptions.  The exchange is a natural market maker and you typically don’t need a flow trader to intermediate. One exception is large sized trades, called block trades typically happen off exchange and utilize a traditional flow trader.

The Investment Bank doesn’t take risk on an agency trade. The Investor decides on the trade they want and the Investment Bank sends the order to the exchange.  In cash equities, Agency traders are called sales-traders, as they don’t have a flow trading book with market risk and a P&L. Sales traders are part sales, and part agency traders. Sales traders advice asset managers on their execution strategy, how to buy or sell a large number of shares without moving markets. They also take orders from investors and send orders to the exchange.

Agency Trading Example

Say you are a Sales Trader at Morgan Stanley (an Investment Bank) and you cover Vanguard (an Asset Manager). Vanguard wants to buy 100 shares of Tesla. They communicate the order to you, “Buy 100 Shares of Tesla at Market”, with at Market meaning that they’ll take the current price from the exchange. The Sales Trader enters that order into the exchange, and the exchange lets the Sales Trader know what price Vanguard bought the shares at. Morgan Stanley collects a per share commission on the trade.  The commission is generally shared between execution (the salestrader) and for research (to compensate equity research).

What is Electronic Trading?

Electronic trading is all about removing human touch points from the trading process.  Salespeople and traders are expensive, and trading in margins in certain asset classes are slim. McDonalds encourages you to use an App or a Kiosk such that your order of chicken nuggets goes straight through to the kitchen. Electronic trading works the same way, and instead of a McDonalds App or Kiosks, we call it a platform or an algorithm. Each bank has their own platform, just like Burger King and McDonalds have separate mobile applications. If you were an investor or a Hedge Fund, instead of calling up Deutsche Bank and asking them for a USDINR NDF (USD Dollar Indian Rupee Non Deliverable FX Forward), you can trade the on the Deutsche Bank Autobahn App.

Electronic Trading develops, sells and supports and trading platform or algorithm. Investors can trade without a calling or a Bloomberg chatting with a salesperson.

Electronic trading works best for simple liquid products where there is an electronic market that could be hedged.  If the platform or algorithm can connect to an exchange and trade equities or futures, electronic trading makes sense.  It also works outside an exchange such as in markets such as FX Spot where market participants have moved to an electronic platform and the algorithm can trade with other banks in an electronic basis to hedge the risk.  Electronic trading currently doesn’t work that well for Credit Trading. In our flow trading example with Tesla, some banks will allow you to trade electronically in small size, but are a long way from trading a social size electronically. The difficulties of hedging the underlying corporate bond positions, including: there are a large number of bonds, each issuer can have hundreds of bonds, new bonds are issued, old bonds mature, not every bond ends up being traded each day.

What do “traders” in Electronic Trading do?

I put traders in quotes – as in most cases, you’re not technically a trader. Another trader owns the trading position and risk, while the Electronic Trading group acts as development, sales and support of the platform. First, you need coders to build the platform. These can be desktop applications, web based application and even mobile applications.  Below is the interface for Deutsche Bank’s Autobahn platform for FX Trading.

Once you build a great interface to use, the hard part is connecting it to your bank’s trading system. These systems are constantly changing so there is a constant maintenance and support system. The profit of electronic trading works the same way as Flow trading. You are trying to cross the bid offers – the 43 and 46 pips shown in the screenshot above. Built into the algorithm is logic on how much risk you can take on and how it hedges. Depending on the system, you can have a traditional flow trader managing the risk position, or have hedging strategies built into the algorithm.

The sales and support function is certainly necessary but the least glamorous part of it. You need clients to sign-up for the platform and you need salespeople to demonstrate the platform to investors (asset managers and hedge funds).  You need an on-boarding team to create log-ins, run through internal know-your-client policies and credit system checks. You need someone to answer the phone when a user forgets their password or doesn’t know how to do something. All important parts of the overall business, but may not be immediately obvious to college students touring a trading floor.

Learn More

We’ve created the Wall Street Prep Sales & Trading Boot Camp from the same materials we teach new hire salespeople and traders at major Wall Street banks. This is a three-day course designed to teach the economic skills, option theory, and bond math that you are expected to know before starting an internship or before moving from the mid-office to the front-office.

Find out more about Wall Street Prep Sales & Trading Boot Camps.

By Eric Cheung

Wall Street Prep Head of Markets Training