CHAPTER 2

A Swift Reality Check

When I was called in to my interview at Swift, I was prepared to sell the experience I had at the time in the finance industry in as many ways as I could imagine. Essentially, I was prepared to emphasize my perceived strengths. I was prepared for a typical job interview.

“Do you play video games?” Liz asked with a straight face. She was the branch manager.

I paused and hesitated to answer. For a moment, I had considered that maybe this was a trick question, like the infamous puzzle questions that Goldman Sachs interviews were notorious for.

“Yes,” I replied. All the while, I quickly ran through in my head all the possible ways this answer might have actually been detrimental to my success as a trader—and I came up empty. Mostly, I was confused and surprised that I had to enter a gray area of honesty on a question like this—the fact was that I had once been a gamer, but not regularly for the seven years leading up to this interview.

As it turned out, experience in video games, while not entirely a prerequisite, was actually considered a practical advantage in the style of frequent scalping that Swift Trade Securities specialized in at the time. The key to efficiently executing manual high-volume scalping was accurate hand-eye coordination, quick reaction time, and preferably the ability to read and react to the visual cues of opponents (and occasionally read between the lines for the true intention of an opponent attempting to veil it with bluffs and various forms of deception).

And much like in a video game, I've come to learn, your greatest threat is not typically your unthinking systematic computer opponents with pre-programmed behavior, especially those designed to perform different primary purposes. Your greatest threats are human traders and algorithm programmers who are more experienced than you at your specific strategy (who, in some cases, may reduce your edge depending on the liquidity available in your strategy)—and, of course, new rules and regulations that may render your strategy impossible or more difficult to execute. In any case, the best defense and offense is to adapt. As long as imperfect humans participate in the markets, and automated systems designed by imperfect humans do so at the same time, it will always be possible to find inefficiency somewhere in the markets.

Another game commonly cited as excellent preparation for such short-term trading styles is poker. In many cases, organized sports experience is also considered an asset mostly for the mindset involved. None of these should be considered prerequisites for success in trading of any style but these skills are certainly advantageous to bring to the table in one of the world's most primal fields of occupation in the modern technological era.

Liz went on to ask if I had ever traded before.

I had just passed the CSC exam (Canadian Securities Course), which is, for all practical purposes, the Maple Leaf equivalent to the Series 7 licensing exam administered by FINRA in the United States, except the CSC was not actually required to trade for Canadian prop firms. I had also traded retail accounts briefly but, like many beginner traders, I was deeply undercapitalized at the time for intraday trading in American equities due to the pattern day trading rule and generally accepted risk guidelines. Overall, I thought I was well prepared to start at Swift Trade Securities on a theoretical and practical level. In hindsight, I would have made a much better trainee if I had carried none of the baggage from educational products targeted at retail traders and long-term investors.

“This won't be easy, you know,” she stated firmly. “You'll have to go three months to a year without pay. Have you saved up for that?”

I confirmed that I had. More likely, I would gradually withdraw from my retail brokerage accounts to cover expenses for the coming months if it came down to it.

She continued, “And most people won't even make it in this business. Ever.”

I've since learned that prop firms commonly “un-recruit” at interviews (especially the first interview, if there is more than one) to filter out the applicants who don't show a real desire to succeed or may simply be unsuitable for the company's internal culture.

Liz went on to pose the question that is, to this day, probably the most commonly asked interview question at every prop firm in the world: “Why do you want to be a trader?”

After listing my past experience in retail trading, I finished: “I've looked at all the upside and downside of giving this a try, all the good and bad that might come of it, just like the good and bad information you'd get before any trade. So I'm looking at this as one big trade. Either I'm going to have to cut my losses and move on, or I'll let this run and make it my career.”

Looking completely neutral and possibly unimpressed, she asked, “But what is it about trading itself that makes you want to do it?”

“I like the control. I like knowing that the decisions I make, the actions I choose to take, will be the reasons for what I get in return for it.”

“What do you know about trading so far?” she questioned.

“Well, I think for the long term, Graham and Dodd style value investing would work; but for the short term, only technical analysis is really practical. Fundamentals should always play a part in it for a long-term bias, but technicals have more influence on the short term.”

She shook her head and paused. “That's like saying the weatherman has influence on short-term weather. You've got things backwards. Do you know what an ECN is?”

“Electronic communications network.” I repeated the acronym from the CSC material but truthfully had very little concept of their actual role on the market. She went on to ask whether I was familiar with crossing networks, the difference between adding and removing liquidity, and other terms that I was less familiar with.

“Good, you're almost a blank slate. I can treat you like one, anyway. Except for all that technical analysis crap. Are you willing to learn to trade like us from scratch?”

I recalled the scrolling green and red lines on the screens and the fascination I had with the apparently alien indicator. “Yes,” I answered. The truth was I was extremely curious to see things from a new angle. And it sure was.

She nodded. “Okay. In the next four days, I'm going to wipe all that crap out of your head and show you how we trade. Come back tomorrow morning.”

The way I saw it, I was about to take the biggest trade I had taken up until that point. I found a rare opportunity with a favorable risk-reward ratio, and I pounced on it. And the only risk capital I really put into it was the potential 6 to 12 months of unpaid work.

* * *

“There are only four of you,” Liz observed as she entered the room the next morning.

It was day one of training.

She continued, “Based on the statistics, less than 25 percent of trainees survive our training program. So, in a way, the odds are against every one of you here today.”

“But for the guys who make it,” Joey interjected, “I heard they're making like 15,000 a day, right?”

“Some of our biggest dark pool traders are doing that right now. But we've also got a couple of traders, good experienced traders, who just can't seem to get past trading four hundred shares at a time. They trade very liquid stocks, too, so it's just a psychological issue. You need to be able to stay calm, watching your unrealized profit and loss go up one thousand, and down one thousand the next second, and up again. You need to make choices as calm and calculated as when it's moving up and down by one dollar at a time. Think you can do that?”

“I used to trade options back in the tech bubble,” Joey shrugged. “I think I can get used to that.”

Liz glanced at the thick technical analysis manual that Joey had been reading all morning. “Week one: Absolutely no charts. If I catch you looking at a single chart, your ass is out the door.” She stated the rule to the group of fresh trainees including myself, and for most people who were vaguely familiar with the information available to retail traders, it sounded a lot like being told you have to run with your eyes closed for the coming week.

In hindsight, I've come to understand the approach that Liz had taken in training and the strategy taught to trainees at Swift in general. I wasn't the only trainee in the room who carried barrels of preconceived notions about trading methods and an overreliance on technical analysis con-cepts for short-term trading. She was in fact forcing us to unlearn a slew of bad habits, to learn the core basics of trading in today's markets, and to reassess our dependence on a tool that is often misused. While I have since branched out to a wide variety of trading strategies, some of which necessitate the use of charts to varying degrees, I realize now that Liz had led me toward a major epiphany in my understanding of the markets by having me kick the chart dependency habit for a full week.

In trading, charts are the most common visualization methods used by beginners, and naturally so, as candlesticks and bars provide methods of visual notation of prices (open, high, low, and close) of a particular period of time. They are readily available on free websites like Yahoo! Finance, Google Finance, and MSN Money. In and of itself, there is nothing inherently wrong with charting the past market data of any asset. In fact, everything from the price of a stock to orange juice can be charted. If one saw fit, the price of a DVD on sale at Walmart can also be charted. The real problem arises when beginners see patterns where there are none, a habit that causes us to tend to fool ourselves into believing that there is hidden meaning in every single event,when sometimes events are simply random or partially random. While the combined effect of capital moving from cash to other assets, and moving between different types of assets, is not necessarily “random” by the true definition of the word, it should also be understood that the combined effect (not the individual entities making each transaction) is often much more random than analysts would like the world to believe.

Like any tool for any profession, technical analysis (or even charting without interpretation) is simply one among many tools that a trader or investor can use to view the past price data on an asset. While a thermometer is an excellent way to judge the typical comfort level of a day's weather, it would not be the best idea to ignore signs of humidity levels, hurricanes, and rain when judging the actual real-life comfort level that should be expected without preparing to deal with these other factors. And there are factors on the market that a simple visual depiction of the open, high, low, and close data simply does not represent—and reading more into patterns, then taking the data and mathematically deriving indicator lines with it, does not magically extract information about the other issues. You can look at a thermometer from every possible angle, and analyze the temperature change patterns all you want, but it won't be able to tell you that it's raining outside.

To take the analogy a step further, it's probably also worth considering that some patterns or events are more likely to be correlated than others. For example, if the thermometer showed a yearly low (based on historical temperatures in a particular city) 10 days in a row, there's a very good chance that it's also snowing outside (if it typically snows in this particular city at the yearly low). However, if the last 10 days were in the middle of the range, and bounced back and forth to create a trend line pattern in temperatures, how sure are you that it will necessarily rain today? While it's human nature to connect both events with equal weight, the reality is that one produces a much higher likelihood of an external event than the other. (Relate this to a stock, commodity, or currency hitting a long-term 10-year high or low price versus a “head and shoulders pattern” in the middle of the range of an afternoon.)

As the first day of training continued, Liz explained to us the basics of choosing destinations (ECNs and exchanges, including those who typi-cally pay you for using their system, and routing to floor specialists); reading the tape and the depth of market (“Time & Sales” and “Level 2 quotes”); the difference between providing and removing liquidity on a real-world double auction market; and managing (not eliminating) risk—specifically, controlling and limiting losses—in short-term trading.

All these concepts are explained, and in many cases updated for today's markets, in the coming chapters.

She had also handed out a booklet containing the current fee structure of each routing destination, which changed every month due to competition between the owners of each venue and the volume that the firm traded through that venue during the prior month. Coming from an informal education in short-term trading from a retail perspective (especially at the time) where commissions can be upward of $30 per trade and still considered acceptable, the fees listed on this booklet seemed so small that I was almost surprised they bothered to list them at all. “0.0025 per share” was listed for one of the ECNs. There were even more zeroes to some of the other fees listed on the page. Better yet, some of the fees were negative numbers—meaning companies actually paid you to trade through their system, a concept completely unheard of among the retail brokerages at the time (that I was aware of).

Of course, with a fee structure at this level, it made sense to me when I learned that many of the firm's top traders would scalp upward of tens of thousands of shares per trade. (It's worth noting that as of this writing, there are a few retail brokerages offering commission structures and pass-through ECN rebates that come very close to the standards of prop firms at the time I started in the industry.)

* * *

At lunch hour, the trainees had the chance to walk around on the firm's trading floor and look over the shoulders of the full-time active traders. There were televisions mounted from the ceiling showing CNBC (an American financial news station) and one by the trainee section showing the Canadian ROB TV. At the time, I remembered wondering why the trainees were given the Canadian financial station as an alternative source of ambient noise while being required to practice only on NYSE listed stocks. Of course, that was a small mystery among the mysteries on the trading floor from the perspective of a day-one beginner.

Many of the senior traders were seated prestigiously at the front row of the trading floor—which, at this branch, contained some of the few seats with flat-screen LCD monitors and comfortable executive chairs—and they would work through the “slow” lunch hour and scalp highly liquid (but very low volatility) stocks using sizes upward of tens of thousands of shares per trade.

It was a different world from the universe of sheltered academic theory and retail education material that I had been familiar with before becoming a trainee.

The sizes of these traders' positions were not about a percentage allocation of a portfolio but rather the size of one penny of volatility. It didn't matter whether the stock was $2 or $4 per share at the time—the size of the trade was determined by the trader's advancement in skill and consistency in the sheer ability to, repeatedly, pull one penny at a time in profit out of a stock that barely moved through the entire lunch hour. Their losing trades, I observed, could barely qualify as a losing trade by regular definitions. In fact, aside from an occasional one penny loss, their contingent exit would typically be the break-even point of the trade. Their only loss would be the transaction fees that the exit would have entailed.

“You ever traded before?” A senior trader named Ron asked without taking his eyes off the red and green lines of text scrolling on the right side of his main screen.

“Just longer term stuff. Nothing like this,” I answered as I hopelessly attempted to understand all the information that was displayed on his monitor.

On a window titled Time & Sales, I saw the scrolling green and red lines that I had seen before from the other side of the glass. Up close, I could see that they were lines of text. Each line of text showed an exact time (for example, 12:03:45, representing the exact hour, minute, and second) followed by a price, a number of shares, and a letter.

“That's just dreaming,” he replied with a subtle shake of the head. “See this right here? This is reality.”

Everything I had learned up until that moment would contradict his statement, but it was a day to adapt in many ways, so I didn't argue. Even if I were a Security Analysis thumping member of the Graham and Dodd religion, seeing the five-digit positive number on his profit and loss window would probably be enough to hold my theoretical arguments in and to keep an open mind to his statement. It was the start of a period when I believed that I had at least partially been brainwashed by the academically accepted belief systems in the finance industry. Accepting a position at Swift Trade Securities was about giving it a shot from a different angle—the practical side of the markets on a short term horizon where academic theories and beliefs had no place, only quick reactions and the bottom line.

While I'm sure a number of academics, as well as traders and investors who successfully employ other styles of trading, would firmly disagree with Ron's outspoken stance on the reality of the markets, I would later realize that his statement was a little more universally accurate from a literal standpoint than I could remotely grasp at the time he stated it to me. It can't be denied that many other factors generally influence the long-term valuations of equities over extended periods of time (the net effect of large supply and demand forces as capital shifts between cash and different assets for any number of reasons), but the current market price on any asset never reflects the true value of the asset—only the current consensus among the capital in the markets on the expected future value of the asset. (The real worth is never fully reflected in prices, only the expectation of future rises or expectations of future drops in value.) And the reality at any given moment during the trading day is, in fact, exactly the information that Ron was staring at on his trading screen. Everything else is theory, opinion, and belief. However, the line of text under Time & Sales showing that 100,000 shares of a stock were sold directly to the bid, reducing the bid size, half a second ago is a fact. Ten more, relatively smaller, transactions following that transaction, looking ready to wipe out the rest of the bid, is fact. Being able to tell that the price is about to go down in this scenario is not rocket science.

The information on his trading platform was not about predictions or opinions—it was a snapshot of the reality in the market at one particular moment for a trader to react to.

Opinion and strongly held beliefs can make for entertaining financial TV programs, which many prop firms—including Swift at the time—will continue to show on the trading floor, but they are often used as pure entertainment by most of the traders and have no real place in short-term trading (except possibly for reminders about major economic announcements such as the Federal Open Market Committee minutes.) Occasionally, a trade may work out based on such opinions and views, but the same trade could have worked out if you had traded on the belief that every day it rains will produce twice as much volatility on the stock at a particular minute of the day. Opinions and beliefs provide no consistent edge on a real intraday market. Risk-controlled reactions to reality (and knowing how to interpret the reports of that reality) do.

What amazed me most at the time was that despite all the hype over automated trading systems and algorithms, I was watching an actual human, using a keyboard like a video game controller, take significant amounts of profits out of the market by watching nothing but the scrolling lines of text that showed every trade that had taken place in as close to real-time as one would ever need. And speaking in hindsight, I can reaffirm that while many challenges (and sometimes advantages) have come and go for prop traders in the years since, it still remains viable for a human to participate, and to take profits out of the markets, using the same classic tape reading techniques. The only real variance in time periods is the degree of profitability that can be found in this type of strategy, and that has varied between months within the same year due to many market factors. This is one of the reasons many traders who began as scalpers tend to add other strategies into their arsenal to take advantage of other opportunities that may at times be more efficient than scalping profits depending on market conditions and seasonal factors.

I'm by no means implying that scalping for pennies is the only way to take advantage of tape reading skills, nor is it typically the single most efficient method of making profits in today's markets (as a broad generalization). In fact, for most traders outside of a proprietary trading environment—especially compared to the extremely low transaction costs at Canadian firms who trade on the U.S. markets, which are almost one tenth of the standard among American firms of the same type—this particular style of trading is simply not cost efficient to the majority of the world aside from traders at a few institutions. However, the core concepts behind tape reading techniques can and should be used for cost-saving entry and exit methods as part of many other trading strategies, even ones that may aim for significantly larger profit targets. The cost of transactions will add up over time, and the opportunities for cost saving are readily offered by the market centers for the taking. Learn to claim it, and odds are it will make a significant difference to your bottom line at the end of the year. At the very least, tape reading can enable a trader to see a better time or price to enter the market and get paid to either add or remove liquidity (depending on the choice of destination, which I elaborate on in a later chapter); this may reduce or eliminate commission expenses at some deep discount direct access brokerages.

Another thing that caught my attention at the time was his layered use of risk control. By scaling in and out of his massive positions, he was able to constantly reduce each trade's risk to less than the size of his average profit-taking size.

While many beginners are taught to adjust their psychology to accepting losses (which is actually an excellent way to start any trading career), the real market is never as black and white as these sorts of theories might imply.

In the afternoon on day one, Liz handed out sheets of paper with a blank grid on them. Above each column of the grid, there were headings that read “High” and “Low.” To start, we were allowed to choose any two stocks within a set criterion to learn with. The criterion was that the stock must be NYSE-listed, it must average over 2 million shares per day in average daily volume, and it must have an average daily range of less than 50 pennies. Every hour of the trading day in training, we were to fill out each of the stocks' highest and lowest prices of the day (as of the hour) on the sheet.

She then explained the details of the Time & Sales window, also known as “the tape,” that I had seen on Ron's trading platform. The information displayed on it is every transaction reported by the Consolidated Tape System for the stock in question. The basic premise of the tape has not changed in over a century, but the nature of the markets has. Today, U.S. stocks (as well as many international stocks as of this writing) do not trade only on a single exchange. They trade through a large number of regional exchanges, most of which are electronic order matching networks, as well as the NASDAQ (and the regional exchanges that it now owns); NYSE (as well as the Archipelago ECN that it took over a few years after my training at Swift); and new competitive exchanges like Direct Edge and BATS Trading (both of which had been ECNs at the time of my training, but are both currently operating dual exchange platforms as of this writing). At any given time on a highly liquid stock like General Electric or Bank of America, every single one of these trading venues, as well as non-displayed venues called dark pools (created originally to facilitate large institutional orders with minimal market impact), will actively facilitate trades of the shares of these names throughout the trading day. (The tapes on the screens mounted at the top corners of the room that I had previously seen through the window were the live Time & Sales data for the S&P futures contracts and the NASDAQ futures contracts. The only difference in those were that they were only traded on the CME at the time with no other exchanges or ECNs to report. The futures data was used as part of a basic scalping strategy that Liz would teach us later.)

Using this system in combination with the Level 2 quotes enables a trader to hone a skill set known as tape reading.

The Level 2 quote is also known as the depth of market or simply the book. It shows the number of shares posted as limit orders on the national best bid and offer (NBBO) on each displayed trading venue (such as NYSE, ARCA, BATS, etc.), as well as at each out-of-market price level above and below the NBBO. With the Time & Sales and Level 2 windows on a direct access trading platform, a trader is able to see the objective reality of the market at any given moment, whether the goal is to enter a long-term position or to simply scalp for a one penny movement.

As competition in ECNs, dark pool crossing networks, and algorithmic systems ramped up in the years to come, a new dynamic would create many different opportunities and strategies for traders to make use of these trading venues. For instance, as of the time of this writing, some venues will pay you if your trade was executed as a limit order that joined the bid or offer (adding liquidity) while others pay you to enter trades that remove shares from the currently displayed bid or offer (removing liquidity). More recently, there is even an ECN platform that places you ahead in line if your order is larger than the orders currently posted on their system (as opposed to price-time priority used by typical publicly displayed ECN systems.) I cover this in more detail in the coming chapters.

After my first day of training, I delved further into all this by researching every aspect of ECNs, tape reading (Level 2 quotes and Time & Sales data), the basics of double auction markets, and the history of the exchanges. At the time, I had decided that the more information I could gather on this material, the better prepared I would be when it came time to face the real market when Liz gave us access to a live account to trade.

For traders with a longer term horizon, these are basic tools of the market that can serve as a method of reducing overhead costs and optimizing entries and exits in terms of both price and time. For short-term traders, they are the key to watching the road ahead instead of staring only at the rearview mirror.