Today the market is entirely electronic.
You generate digital order tickets and route them to an electronic exchange that automatically matches your orders with corresponding orders, or else it sits on the digital order book waiting for another trader to route an order that satisfies it.
Outside of some hiccups created by high-frequency traders, it’s all so elegant and efficient.
But, what about the time before everyone had computers? What was it like before?
There were floor traders.
These were members of a physical securities exchange who took orders from customers over the phone, with the obligation to either trade against the order, or find another trader in the pit who would take the other side of the trade.
To many younger traders like myself, it’s perplexing to see these guys pushing each other around in a big hall, screaming “buy, sell!” with no apparent rhyme or reason behind it all.
Older trading books like Market Wizards are packed with interviews with very successful floor traders explaining their time-tested trading principles that brought them immense riches.
Cut your losses quickly, size your bets effectively, the trend is your friend were all mantras of these traders, but how were they generating trading signals?
What about technical, fundamental, or quantitative analysis? How did these traders make profits simply by standing in a pit and trading verbally with minimal analytics at their grasp?
Floor Trading Edges
Still, the question remains: how did floor traders generate a trading edge?
Today, electronic traders might use technical patterns, fundamental factors, sentiment analysis, or elaborate statistical arbitrage tactics to find trading edges and use them for trading.
For the most part, Floor traders didn’t have much in the way of analytics or computing power, so was it just gut instinct? Partly.
The primary way floor traders generated an edge was through market-making.
For the most part, they bought on the bid and sold on the ask, collecting the spread. They did this many times, all day, while managing their inventory to ensure they don’t get too long or short on one side of the market.
They instantly profited on almost every trade by virtue of earning the bid/ask spread. Do this enough times, and it doesn’t really matter how you’re generating trading signals so long as you’re managing risk.
William Eckhardt, known for his famous bet with Richard Dennis, which resulted in the Turtle Traders, had this to say about floor trading edges:
Off-the-floor traders live or die by their ideas about the market or their systems. That’s not true of floor traders. As a pit trader, you only need to be able to gauge when a market is out of line by a tick, or a few ticks. Once you master that skill, you tend to survive, whether your underlying theory is sound or not. In fact, I know a lot of pit traders who subscribe to various bogus systems: moving averages, lunar cycles, and god only knows what. When they get signals from these systems, they essentially buy on the bid or sell on the offer. At the end of the month, they have a profit, which they always attribute to their system.
Essentially, floor traders had lots of fancy ideas and systems, but most of the time, you were able to reduce their edge down to the fact that they were earning the bid/ask spread on most of their trades.
Because most floor trading was done pre-decimalization, the spreads were pretty huge, especially when you were trading big size.
As a result, as long as you were buying at the bid and selling at the ask consistently, you could generate trading signals by only trading when the second hand on your watch was at a prime number and still make money.
Furthermore, before trading was electronic, markets were much more inefficient. Securities were often structurally mispriced because traders and portfolio managers by-and-large didn’t know how to value them correctly.
A trader with the most basic knowledge of options pricing theory was able to harness massive edges. “In the land of the blind, the one-eyed man is king.”
This is precisely how super-trader Linda Raschke got started trading on the Pacific Coast Stock Exchange floor.
She didn’t do the elaborate math required to derive the Black-Schools theoretical value of options but instead used the intrinsic value and used the underlying security’s historical and expected volatility to determine if an option was mispriced.
Types of Floor Traders
There were floor traders and brokers.
The traders traded for their own account or their firm’s trading account and got a cut of the profits. As we went over in the previous section, their primary edge was market-making–standing willing and ready to buy at their stated bid price and selling at their asking price.
They made lots of money when customers “crossed the spread” or sent what was effectively a market order, buying or selling shares at whichever price was immediately available for execution.
If their customer crossed the spread, the trader could buy shares relatively cheap or sell them relatively dear. They can then flip the shares they just got at a good price and make a few ticks of profit.
Do this several times throughout a day, and you’re bound to make money at the end of the month.
If this is a little confusing, let’s do a thought experiment.
Perhaps a customer called you and asked for a quote for 100 shares of AAPL, and you quoted them 123.00-124.00. If the customer lifted your offer, you can turn around and buy the shares that you just sold for 124.00 for 123.40, picking up a 0.60 profit.
Of course, this wouldn’t happen nowadays, and things were hardly this simple, but it demonstrates the built-in edge that floor traders had.
This is very much what high-frequency traders do nowadays, except they pick up a penny or less for each trade, rather than 0.60.
Their business relies upon them making thousands or millions of trades per day, while floor traders could never have dreamed of trading that frequently.
While the edge was there, it wasn’t as easy in theory.
Perhaps a floor trader filled a sell order at the bid, but then the entire floor received a barrage of sell orders, pushing the price down significantly. Now that floor trader is stuck with a block of stock that he just bought at a much higher price.
Many times, floor traders interacted with informed order flow–big and smart money managers who were the most informed on where the price might go next. Even when you can make the spread, taking the other side of Paul Tudor Jones’ or George Soros’ trades can still leave you with massive losses.
The brokers stood on the floor and worked orders for clients.
Perhaps a mutual fund client needed to buy 10,000 shares of IBM. The broker would try to buy as low as possible, perhaps after a block order was just sold into the market.
They would take advantage of the market makers who were long a lot of stock and needed to unload it quickly to balance their inventory. These brokers would get compensated through commissions and incentives for getting good prices, rather than pure trading profits like the floor traders did.
Brokers who couldn’t get good prices for their customers faced stiff competition–there was always another broker waiting in line to work that mutual fund’s orders.
Institutional traders like mutual funds or hedge funds established relationships with several brokers and would get quotes from several brokers or even slice their order into smaller pieces, feeding each broker a piece of the large block.
The Death of the Floor Trader
Floor trading is basically dead.
A limited number of floor traders still do it, but more than 95% of the order flow is completely electronic nowadays.
Even Peter Tuchman, the famous NYSE floor broker, frequently photographed in the financial press, told the German press in 2017 that he only had two clients left.
These guys were making millions. Just read the early Market Wizards titles.
What happened? Computers. Frequent traders were wise to many of the tricks floor traders would play on them, like backing away from quotes or refusing to quote a reasonably tight spread when the markets got volatile.
Institutions that felt stiffed by floor traders were the first to hop on the electronic trading train. And there was a viable new solution: Island.
The Island ECN was one of the first automated electronic trading exchanges. Instead of routing your order to the trading floor, you could route your order to Island for immediate execution.
The platform used a matching system much like the ones used in modern exchanges. If your buy order for $10.00 matched with a resting sell order for $10.00, the trade would be automatically executed for $10.00, virtually instantly.
Not only was this a cheaper and faster way to trade, but it offered incentives too.
Those adding liquidity–submitting orders that weren’t eligible for instant execution, would get paid modest rebates for not taking liquidity away from the market: this attached high-volume market makers and day traders.
The other primary factor in the death of the floor trader was regulatory.
To adjust to the new day of electronic trading, the SEC forced all trading venues to convert from quoting equities and options in fractions like $34 ⅜ to decimals like $34.38.
This resulted in much tighter spreads, allowing traders to price-improve orders by merely a penny instead of an entire eighth of a dollar. This destroyed one of the major edges of floor traders: wide spreads.
Couple together decimalization and the rise of electronic trading, and it became clear that the world wasn’t long for floor traders. Throughout the early 2000s, exchange trading floors quickly became deserted as most floor traders moved to off-the-floor trading, went broke, or found a new career.
As a demonstration of this, former CME floor trader Jimmy Jude told the Market Huddle podcast about the time he took advantage of a dying, inefficient trading pit as they were becoming obsolete: the New York Mercantile Exchange (NYMEX).
After leaving the CME, Jude joined an electronic prop firm that needed a former floor trader to take advantage of the inefficiencies they were spotting on the NYMEX.
He noticed that the futures trading on the NYMEX were trading at different prices than on electronic exchanges. He brought a handheld computer into the pit, and put on spread trades between the electronic contract and the physically delivered contract trading on the NYMEX.
He called it the “easiest trade of his life” that “probably made $10 or $12 million.”
Outside of hard-nosed experience and broad lessons about trading, the lessons from floor traders in old trading books have very limited utility in today’s market. Things are so different and so much more efficient.
However, one of the key lessons to learn from ex-floor traders who were able to migrate to off-the-floor trading successfully is to be wary of your edge because it might be gone sooner than you think.
Countless floor traders were making millions a year in the 80s and 90s whom one day realized that their job had been automated away, with no backup plan. If you’re taking advantage of a very strong edge, the chances are that other traders will find it and exploit it one day.
If you bank on that edge paying your bills in perpetuity, you’re going to end up like many floor traders in the early 2000s.