1.1  The Trading Industry

1.1.1 Traders

Traders are people who arrange trades for themselves, have others arrange trades on their behalf, or arrange trades for others.

The two sides of the trading industry. In a completely frictionless market where two people exchange goods directly, separate sell-side traders may be unnecessary. In real markets, however, traders face tasks such as finding counterparties, routing orders, quoting prices, making immediate execution possible, handling settlement, and providing financing. Specialized traders and institutions emerge to meet these needs. Exchange services provide the liquidity and immediacy that make trading possible. To understand today’s trading industry, it is useful to distinguish the trades themselves from the services that make them possible. For example, client \(A\) may place an order with a broker, who then finds another trader willing to take the other side and arranges the trade:

\[A \longrightarrow \text{broker} \longrightarrow B.\]

In this case, the actual economic counterparties—the buyer and the seller—are \(A\) and \(B\). The broker earns a commission from \(A\). When a dealer is involved, on the other hand, the transaction may take the following form:

\[A \longrightarrow \text{dealer}.\]

Here, the dealer acts as a principal and may take the assets into its own inventory. The dealer earns profits from its own trading. Many sell-side firms employ both brokers and dealers and are known as broker-dealers or wirehouses. Goldman Sachs is one example.

1.1.2 The Buy Side

The sell side exists only because the buy side is willing to pay for its services. We therefore need to understand why the buy side trades before we can understand when the sell side is profitable.

Types of buy-side traders: Investors and borrowers. If you have surplus money today but will need it in the future, you become an investor. For example, if you have 10 thousand dollars today and want to use it in ten years, you may buy stocks or bonds to transfer wealth from the present to the future.

\[\text{present wealth} \longrightarrow \text{investment} \longrightarrow \text{future wealth}.\]

Conversely, if you need money today but expect to earn income in the future, you become a borrower. Typical examples include a student taking out a student loan or a young couple using a mortgage to buy a home.

\[\text{future income} \longrightarrow \text{borrowing} \longrightarrow \text{cash available today}.\]

Therefore, investors move money from the present to the future, while borrowers move money from the future to the present.

The hierarchical structure of the buy side. To understand why a trader trades, we need to look beyond the order itself to the investment objective behind it. In many cases, this means considering not only the trader but also the people and institutions connected to that trader. For example, an investment sponsor provides the objectives and capital, an investment manager decides which assets to hold and in what amounts, and a trader turns those decisions into actual market orders:

\[\text{investment sponsor} \longrightarrow \text{investment managers} \longrightarrow \text{traders} \longrightarrow \text{market}.\]

For instance, a sponsor may set a long-term allocation policy of \(60\%\) equities and \(40\%\) bonds. If the investment manager then decides to increase the portfolio’s allocation to Apple from \(2\%\) to \(3\%\), the trader determines how many shares to buy, at what prices, and how quickly. These three roles may exist within a single organization or be entirely separate. The people and institutions that ultimately benefit from the funds held by investment sponsors are called beneficiaries.

1.1.3 Exchanges

Exchanges provide forums where traders meet to arrange trades. Only members can trade on exchanges; nonmembers ask member brokers to trade on their behalf. Today, traders meet exclusively through electronic communications networks. Examples include the Nasdaq Stock Market and the Chicago Mercantile Exchange.

1.1.4 Trading Instruments

Traders trade trading instruments, which include real assets, financial assets, derivatives, and other instruments. Financial assets and derivatives belong to the class of financial instruments.

Class Instrument Creators
Real assets Spot commodities Farmers, miners, and manufacturers
  Real estate1 Builders
  Intellectual property Inventors and artists
Financial assets Stocks2 and warrants Corporate issuers
  Bonds3 Corporate issuers and governments
  Currencies Governments
Derivatives Futures, options, and swaps Sellers

Financial assets. Financial assets are a class of instruments that represent financial claims on issuers. They also include bank deposits and loans receivable. Within this class, securities, also called issues, are standardized financial claims issued in a form that can be transferred and traded. New issues trade in primary markets when issuers first create and sell them. Subsequent trading takes place in secondary markets, where these instruments are known as seasoned issues. For example, primary trading in new equity issues takes place in the initial public offering (IPO) market. The two main subclasses of securities are equity securities and debt securities:

  1. Equity securities: These represent ownership claims on a corporation or business.
    • The most typical example is common stock. When a company performs well, shareholders may earn substantial returns through dividends and share-price appreciation. If the company goes bankrupt, however, debt holders are repaid first, and equity holders receive only the remaining residual value.
    • Exchange-traded funds (ETFs) are mutual funds4 that trade on exchanges. Most ETFs are index funds.
  2. Debt securities: These represent contractual claims on an issuer for repayment.
    • A typical example is a bond issued by a corporation. If a company issues a bond with a face value of 1 thousand dollars, for example, the bondholder becomes a creditor who has lent money to the company.

Derivatives. Derivatives derive their values from the values of the underlying instruments. Since sellers create derivatives when they first sell them, derivatives are in zero net supply. All derivatives have futurity: their values depend on future events. Almost all derivatives have an expiration date, on which traders make the final settlement and the contract expires. Derivatives include the following:

  1. Forward contracts: Forward contracts are contracts for the future sale of a commodity.
  2. Futures: Futures are forward contracts guaranteed by an exchange clearinghouse5. The clearinghouse acts as the buyer to every seller and the seller to every buyer. Futures traders therefore need to consider only the creditworthiness of the clearinghouse.
  3. Options: An option gives its holder the right, but not the obligation, to do something. Option contracts give their holders the right to buy or sell an underlying instrument at a fixed price. The trader who sells an option contract is called the writer, and the option is said to be written on the underlying instrument. A writer may write a call option, which gives the holder the right to buy at a fixed strike price, or a put option, which gives the holder the right to sell at a fixed strike price. In an option contract, the buyer, or holder, pays a premium to acquire this right. The writer receives the premium in exchange for assuming the contractual obligation if the buyer exercises the option. A call writer must sell the underlying instrument at the specified price, while a put writer must buy it at the specified price.
    • American-style option: The holder can exercise the option at any time before the expiration date.
    • European-style option: The holder can exercise the option only on the expiration date.

  1. Property consisting of land and the buildings on it, together with natural resources such as growing crops, minerals, or water. ↩

  2. A single unit of stock is called a share. ↩

  3. A certificate issued by a government or a public company promising to repay borrowed money. ↩

  4. A mutual fund is an investment vehicle that pools money from multiple investors to purchase a diversified portfolio of stocks, bonds, or other securities. ↩

  5. Clearinghouses settle all trades in derivatives. ↩