Sunday, December 03, 2006

How Trading on the Screen Differs From the Floor

Let's say that you wanted to sell your car at an auction. It's a several year old sedan with average miles in very good condition. How would you price your vehicle?

Well, you could look at a guide, such as the one published by NADA, and that would provide a good starting point.

The reality is, however, that how much money your car will fetch will depend upon how many other, similar cars are available for sale at the auction. You need to know if it's a buyer's auction, with lots of recent model sedans available, or a seller's auction, with few such cars on the market.

Moreover, you would look to see who else is participating in the auction. If you saw a representative from Hertz pull into the auction with a fleet of sedans to sell off, you'd want to sell your car as quickly as possible (before the fleet) and take the best price you get. Conversely, if you saw a group of used car dealers wanting to buy cars for their lots, you might price your vehicle more aggressively.

Chances are, with Hertz in the auction, you would accept the highest bid for your car. When the dealers are in the market, they might have to compete with each other and grab your car at the price you're offering. The transaction at the buyer's bid price or at the seller's offer would tell you whether it's a buyer's or seller's market.

On the floor, in the commodities pits, you can see who is buying and who is selling--a bit like the auto auction. You know who the locals are, and you can see brokers come into the pit with orders from "paper"--the institutions. You actually see and hear the volume being transacted and can see prices move or stall as locals make markets. Most important of all, you can see from the activity of the participants whether it was a buyer's market, a seller's market, or a dull market with locals trading back and forth with each other.

The market's auction process is far less visible on the screen, which is why successful pit traders are not always successful when they move to electronic trading. They no longer have the visual and auditory cues when volume picks up and, most important of all, they no longer have that feel for who is in the marketplace. Imagine selling your car at auction and finding out that Hertz has just placed 100 similar cars alongside yours. That happens on the screen to new traders all the time.

This is why I consider volume analysis to be important to short-term trading. By decomposing volume into component trades, seeing what is happening with large vs small trades, and seeing which trades are occurring at the market bid or offer, the screen trader can regain some of the edge of the pit trader.

Here is a worthwhile exercise for former pit traders adapting to the screen (and for new electronic traders): Watch volume on a 1-minute basis and see where volume expands significantly and remains elevated for several minutes at a time. This elevation is created by large traders entering the market. Look at what was going on in the market to trigger these large trades. Maybe it will be a technical event, such as breaking a support level. Perhaps it will be a news item or economic report. Other times, it will be triggered by a move in a related market, such as bonds, the dollar, or oil.

By watching, watching, watching those volume elevations each day and what causes them, you begin to think like the large traders. You gain familiarity with the rules of the game that they are playing by.

And *that* is an edge.