Unleash Different by Rich Donovan

Author:Rich Donovan
Language: eng
Format: epub
Publisher: ECW Press
Published: 2018-09-04T00:00:00+00:00

Chapter Sixteen

The Physics of Markets

When I joined Merrill, the traditional trading desk was dying. The portfolio trading team was tasked with building the automated system that would represent a new era in stock trading. The idea is simple. If a house can understand the risks of a portfolio of stocks as opposed to the individual stocks, it can consolidate the number of traders required and be able to give customers better prices and execution, not to mention making more money for shareholders. Every house on the street was racing to improve automation, and Merrill was starting in last place.

Until the early 2000s, successful traders had to have an intimate knowledge of each stock. They had a book of stocks, perhaps twelve of them. If a trade came onto the desk to sell IBM, say a million shares, it would get routed to the trader who traded IBM. The trader was the house expert. She either decided to keep that in her book or sell it to the market. That trader was uniquely qualified to make that call because she knew what IBM was up to, she understood what was coming down the pipe, she understood the earnings, she understood the fundamentals of the stock. So if one trader can trade twelve stocks and Merrill needed to cover two thousand stocks around the world, that’s a lot of people. Now think how all those stocks behave differently—or not. The reality is you’ve got positions in two thousand stocks that move in similar and different ways to create an entire portfolio for a trading position in Merrill’s book.

Trading on a stock-by-stock basis across fifty or a hundred traders is just not an efficient way of doing business. To understand how automation fixes that, you must understand how trading works. At its most basic level, trading is buying or selling stock. A trader’s job is not to hold stock but to exit a position, with zero position being normal. What determines how a trader exits is what the transaction to exit will cost. Most people don’t understand this. They think traders are just buying, selling, taking a profit. That’s called market making, but we were doing more than just that.

On most occasions, we bought risk from clients—meaning clients paid Merrill a certain amount to take stock off their hands. Let’s say a pension plan fund manager calls up and says, “I have a position of one million shares of McDonald’s that I want you to buy.” The fund manager is calling all his contacts on Wall Street. He’s calling Goldman, he’s calling Merrill, he’s calling J.P. Morgan. He’s shopping the McDonald’s shares to see which bank will give him the best price. If Goldman says that they will charge seven cents a share worth ten dollars to take that onto their book, J.P. Morgan says they will do it for six cents and Merrill says it will cost twelve cents, J.P. Morgan wins the trade. J.P. Morgan has now assumed

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