Following on from my previous post, here is a brief summary of some of the more important players that operate in the market and how they work:
Governmental institutions
One such governmental institution that we hear about in times of crisis is the US markets Plunge Protection Team. Former president Clinton advisor, George Stephanopoulos told “Good Morning America” on Sept 17, 2001, “There are various efforts going on in public and behind the scenes by the Fed and other government officials to guard against a free-fall in the market. The Federal Reserve, big major banks, representatives of the New York Stock Exchange and the other exchanges have an informal agreement to come in and start to buy stock if there appears to be a problem. They acted more formally in 1998, during the Long term Capital Crisis, and propped up the currency markets. And, they have plans in place if the markets start to fall.”
So, instead of flooding the entire economy with liquidity which would increase the risk of inflation, the theory is that the Fed could support the stock market directly by buying market averages in the futures market, thus stabilizing the market as a whole.
This team is theorised to act at key levels such as new lows (thus creating a technical double bottom) or at major round numbers. By doing this they force bears to cover and attempt to initiate fresh technical buying into the market place.
As well as the PPT, central bank intervention is another key factor to consider. This is where a central bank buys or sells its own currency in order to drive it to a level that is in accordance with its objectives. Central bank intervention can take place in currency markets when they get drastically out of line and threaten to affect local economic conditions.
Banks
Banks role in foreign exchange transactions is particularly interesting. Banks make a good deal of profit in the FX markets and one reason for this is the lack of a central clearing mechanism for FX transactions. A customer that trades with a bank must, for all intents and purposes, exit a position at the same house it was entered. As a result of this, the bank always knows which way the customer will go.
Since money must also be deposited in advance of taking a position and most customers leave just enough funds to cover the size of their positions, the bank is able to know which way the trader will go once it has used up its available margin funds. They can use this to their advantage in quoting a spread on a large transaction.
Niederhoffer gives an example in his book "Education of a Speculator": "Assume a customer with $10m on deposit, as a 5% margin against the value of foreign exchange, holds long positions of $200m. If the customer asks for a quote, the bank will know he has to sell dollars and will be inclined to quote a bid/asked spread that is biased to a low dollar bid".
Banks talk also to not only each other but they also have lines with all the biggest brokers and get to know the big traders and how they trade. According to Niederhoffer the big banks keep computer programs that indicate the likely direction of each trade and whether the customer is a trend follower, a pyramider or a stop-loss kind of trader. Monitoring its customers can give banks the same kind of edge that poker players stive to get by watching the other players to spot regular patterns in the way they play (do they play ever hand, do they always bluff, are they a weak hand that will fold if pressured etc)
They also have information that is detrimental to the public. They know where all the customers stops are. And can share this information freely with other banks in their network.
Dealers
Dealers usually make a profit on the bid/asked spread. This is their bread and butter. In some markets and with some firms the spread is so wide that the profit potential is huge. If you take a spreadbetting example, the spread on Euro Dollar in most spreadbet firms is 2 ticks. If I want to buy they can quote me 135.60 - 135.62. If I decide to be a buyer at 135.62 they can immediately go long the equal amount and capture the spread of 1 tick. If I do only a 1 lot (£7 per tick) then their commissions are £7 for a trade which is close to extortionate.
Savvy (and unethical) dealers can try to gain an advantageus position over their client by enquiring of the more naive ones whether they want to buy or sell before they offer the spread.
Also while we are on the subject of dealers that aid the order flow, it is worth noting that off exchange transactions can occur. For example, if you wanted to buy 5,000 lots in the FTSE future, you wouldn't hit market as you would take out every offer and get a terrible price. You would, in the most likely scenario, ring Liffe and have your bid matched up with another offer of equal or similar size so the market. This can create a volume spike on the chart.
Floor traders
Floor traders profits not only from the bid/asked spread but also as a direct result of the public's losses from slippage on their entries.
Floor traders are right at the centre of the action and can become more efficient at profiting in the game by such tactics as front running large orders that come onto the floor, running stops and quoting excessive spreads.
Prop traders
Prop traders, at least most of the ones I know, are looking to make regular profits in the market. They study the price action and what other locals are doing. They watch carefully to see where and how another trader of group of traders are accumulating (buying) where and how they are distributing (selling) and try to work out where they might need to puke (get out).
A very common technique for profiting that is used by prop traders is front running size on the bid or offer (watching carefully to see if its a spoof which is not a genuine bid or offer but one intended to give the impression of buying or selling).
A few traders at my firm made hundreds of thousands of pounds when they realised back in January that whilst all the US and European markets were going down, someone was coming in as a buyer in the Dax towards to close and holding it up. When they noticed this, they knew that it was going to be forced lower once the buying had dried up so they would sell it each day on the following open. It was later theorised that the buying came from Jerome Kerviel, the rogue trader of Societe Generale. When it came to light what was going on, the bank was forced to close out the huge long positions that Jerome had been accumulating over three days of trading beginning January 21, 2008, a period in which the market was experiencing a large drop in equity indices, and losses attributed are estimated at €4.9 billion. Of course, the traders that spotted it and knew he would be forced to puke, made a fortune very quickly.
Producers
Producers often have an intimate knowledge of their product and the conditions surrounding supply and demand. This knowledge is an advantage in dealing. However, one should not forget that producers often have to hedge their inventory and so have no choice whether they enter the market and in what direction. If a Wheat producer needs to hedge his stock or a country needs to tender 100,000 bushels of Wheat then that order will make its way into the market and price will be affected accordingly.
This is really just a brief summary and should just provide some food for thought.I highly recommend anyone read Victor Niederhoffers "Education of a Speculator". One chapter in particular deals with the players in the trading game and its called "The Ecology of Markets". It is a VERY fascinating read into the dynamics of the markets and how the players interact with each other to "eat" the public who are the lowest in the markets "food chain".
