The Smart Profits Report: Issue #241
Friday, September 9, 2005 Market Makers - Hand Signals, Stress and Million-Dollar Trades
By Lee Lowell
Investment Advisory Panelist, Mt. Vernon Research Bottom line: Market makers matter... If you've been reading the articles that I've written for the Smart Profits Report, you know that I was a market maker in the crude oil and natural gas options pit on the floor of the New York Mercantile Exchange (NYMEX). These are commodity options that I'm talking about. So all of the facts that I tell you here today only relate to my experiences at the NYMEX. I know many traders are somewhat familiar with the idea of market makers from the stock exchanges, and I believe they function a little differently from the guys in the commodity option pits. They also get more airtime from the media, so that's why the public hears about them more. But we're all performing similar functions - and it's important for any options trader to know exactly what those functions are... Why? Because without knowing exactly what market makers do, you'll never be able to beat them at their own game - making money on the options markets. Today, I'll tell you how the market maker gets paid, where he fits into the options world in relation to you... and why it's important to understand it if you want to consistently make money in options. Let's get right to it... A Hard-Earned 50/50 Split The market maker generally comes in two types: One that works for a market-making firm, or one that works for himself. I had the distinction of doing both. A market-making firm can be a large company, or wealthy individuals, who will hire traders to become market makers for them in different commodity pits. Examples of firms like this are Susquehanna Investment Group (SIG), Chicago Research & Trading (CRT), or the one I was employed by, First Continental Trading (FCT). FCT was started by an individual who made lots of his money by trading in some of the Chicago markets. He then hired other traders to work - and make money - for him. The market-making firms put up the financial backing for these other traders. By that I mean, the actual market makers need to have an account in order to trade on the exchange, and that account needs to be funded. The firm puts the money in the account and lets the market maker go to work. A typical agreement would have the market maker earning a small monthly draw for living expenses, and then all the trading profits (if there were any) would usually be split 50/50 after expenses. A pretty sweet deal to have someone drop a few hundred thousand dollars into an account for you to try and make more of it. It takes a very confident (and wealthy) person to allow others to use his money on market-making activities. The market makers are spread out amongst the various pits on the exchanges so the firms could have a wide exposure to all the different markets. I worked in the options pit, but we also had guys working in the futures pit as well. (I will explain the relationship between those two in a subsequent article.) At the time, FCT was based in Chicago, and already had a set-up in London. They wanted to break into the New York market, and I happened to be in the right place at the right time. They opened up shop sometime in the summer of 1990 just before the first Gulf War had started. I joined them the following summer as the fourth employee of the New York branch. A Gutsy Proposition Worth 100% of the Profit The other type of market maker, as I mentioned earlier, is the self-employed type who uses personal money for financial backing. In 1995, I had enough experience to think about being in business for myself... and enough money built up that I didn't need anyone to fund me with cash. Now I could keep 100% of my profits. An exciting, but scary endeavor... to say the least. Of course, there was no small salary, no company health insurance, and no other co-workers to share the load with. But it was worth it. When you become a self-employed market maker, you are usually referred to as a floor "local." This just denotes that you are an individual and not really associated with any bigger firm. The way that the market maker gets hired, or actually gets to be a market maker, is different for each company. But the one thing that market makers all have in common is that they have to start out as a floor clerk. If you get hired by one of the bigger market-making firms, your time as a floor clerk could be years. Most of them give the clerks intensive training on their trading philosophy and how to actually learn the mechanics of being a market maker. I will say that being a floor clerk was one of the most emotionally stressful jobs I've ever experienced. One flash of the wrong hand signal (which I'll also explain in a subsequent article) can cause a loss of hundreds, if not millions of dollars. These were all lessons I never would have learned without working in the options pit. And of course, next time I'll show you trading techniques that take advantage of this firsthand knowledge. Today's Smart Profits Crib Sheet Good trading, Lee Related Articles: Smart Profits Report Archive | 
