What You Actually Do In Sales & Trading, Part 2: Equity Trading

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While there are plenty of day-in-the-life and week-in-the-life stories detailing what you do in investment banking, there’s surprisingly little information on sales & trading.

We started to fix that problem by looking at what you do in fixed income – besides bankrupting your firm and causing the economy to spiral into a bottomless abyss.

This article will continue that thread by telling you all about equities, the second major area within trading.

Once again, Jerry’s the expert and the author here, so direct all questions to him.

Quick Recap

Trading is divided into groups depending on whether or not you have clients or you’re making your own decisions – agency trading and prop trading, and then the gray area of flow trading in between.

And then it’s also divided according to what you’re trading – stocks, bonds, currencies, or derivatives of those.

Originally Fixed Income was supposed to mean only securities that involved debt, but these days FX and commodities traders are often put under the umbrella of “Fixed Income” as well inside investment banks.

Similarly, “equities” originally just meant trading stocks of companies, but these days it has expanded to cover a couple different areas.

So let’s delve in and see what you do in equity trading besides gambling, eating junk food, and abusing interns.

Agency Trading

This is the most basic type of equity trading: you work at a sell-side financial institution, like a large investment bank, and you execute orders for clients throughout the day.

You don’t make decisions on what or how much to buy – you just take what the client wants and you make it happen.

Why do they need to go through an investment bank just to buy or sell stocks? Couldn’t they just use E*TRADE?

No – because of the size of the transactions.

Let’s say that a mutual fund wants to buy 1 million shares of Microsoft – if that order were placed immediately, it would be too big for the market to absorb and it would disrupt the share price by quite a bit if they attempted to buy all 1 million shares at once.

So it’s your job to divide this into smaller pieces and buy a portion at a certain interval throughout the day, or through another period of time – usually you follow a fixed schedule for buying the stock (e.g. every 20 minutes).

The only thing you control is how to vary the order timing and order routing – if you work in the US you have more control over these variables because of the sheer number of ECNs (electronic communication networks) and dark pools. In other markets you don’t have as many options.

Pros: If you’re interested in trading but you’re not quite ready for more advanced jobs, this could be a good fit to get your foot in the door.

Also, the work hours are much shorter than most other jobs in finance: you might arrive right before the market opens and leave right after it closes; there’s not much analysis to do since you’re not making your own decisions on what to trade.

Cons: The job itself can be boring at times, and you don’t have many exit opportunities. Also, more and more agency traders are being replaced by automated trading algorithms over time.

Proprietary Trading – Plain Vanilla Equity

Plain ol’ stocks. As cool as “synthetic collateralized mezzanine bespoke hybrid exotic derivatives structuring / trading” might sound as a job title, there are still plenty of benefits to being a normal stock trader.

This is the opposite of the agency trading discussed above, because you’re making your own trading decisions and there are no clients.

You don’t have to deal with too many logistical or IT issues that come with trading over-the-counter instruments, and the market liquidity is excellent in developed markets – so you don’t have to worry about not being able to exit your positions.

Bid/ask spreads are small, trading fees are low, and if you make a mistake you can even undo your trade immediately without much damage. (Note: the Obama administration is currently considering implementing a trading tax that may slightly increase the costs of trading)

The only problem is that there are so many market participants that it’s very difficult to find great trading opportunities that everyone else has missed.

Usually you focus on a specific sector and you hold positions for a few days to several weeks; you normally do both micro- and macro-analysis, though there are some traders who ignore the fundamentals and just focus on technical analysis.

You don’t need to be a rocket scientist to do the job: you just need to be good with numbers and a quick decision-maker.

Pros: More interesting work than agency trading; better exit opportunities within trading; potential to make more money than agency traders.

Cons: Hours tend to be longer, especially if you need to do a lot of analysis; you could argue it’s still less “interesting” than trading more exotic securities.

Proprietary Trading – Equity Derivatives

There’s a smorgasbord of derivatives based on equities, but here I’ll just focus on the most basic one: options.

They’re generally riskier than plain vanilla stocks and require more skill to trade: the bid-ask spreads are higher, there’s less liquidity than with stocks, and any one stock could have a few dozen different options with different strike prices and maturities.

There are also more inputs in valuing the options: just as one example, you need to decide what measure of volatility to use, which makes the task considerably more complicated than just valuing the underlying stock.

The coolest part about options is that you can make a LOT of different types of trades.

One common example is a straddle – buying a call option and put option at the same strike price, which gives you a positive payout if the stock moves up or down past a certain amount by maturity.

Even the names themselves sound pretty creative: besides the straddle, you’ve also got the butterfly, the iron condor, and the strangle.

You can also come up with all sorts of crazy payout profiles of your own by combining options and plain vanilla equities.

Leverage is also built into options, so you can easily quadruple the money you put into one stock option: the risk management department would never let you put most of your money into a single option, but even trading smaller amounts of money gives you an adrenaline rush with options.

Even though more math is required, you still don’t need to be the next Isaac Newton to trade derivatives: being able to derive the Black-Scholes equation from Ito’s Lemma isn’t necessary.

However, you do need to understand the Greeks – how an option’s price responds to changes in time, interest rates, volatility, the underlying stock price, and more. You also have to be good with Excel because you need to make more calculations than plain vanilla equity traders.

Pros: More “interesting” and quantitative than plain vanilla equity trading; you can be more creative in devising your own trading strategies.

Cons: Again, hours are longer than agency trading; more quantitative ability is required; as you move up and become more specialized your exit opportunities also narrow.

Algorithmic Trading

No, I’m not talking about the trading robot here (please don’t fall for that scam).

Also known as algo-trading or program trading, in algorithmic trading you don’t actually trade anything yourself: you just program a computer to trade for you based on technical analysis, market volume, or even parsing news headlines.

To do this, stock analysts need to look at historical market patterns, programmers need to implement the system, and everyone else needs to use, monitor, and configure the system.

Sometimes algo-trading is 100% automatic, but it can also be combined with human trading.

Some hedge funds do 100% algo-trading and have performed well – but ever since the financial crisis and the onset of apocalypse in the markets, many previous market patterns stopped holding true.

The result: trading algorithms that had made a lot of money in the past started losing money and thousands of hedge funds and trading firms collapsed.

That’s not to say this is a “bad” field to go into: it’s just that the financial crisis made it necessary for trading algorithms to change their assumptions, and that may mean more challenges for those designing the algorithms.

When people say algo-trading, you would normally think of proprietary algo-trading – but there’s actually agency algo-trading as well, which focuses on how best to execute a client’s trades.

If you’re coming from a highly analytical or IT background, you like working with data, and you want the thrill of huge trading profits without having to stare at charts every second, this could be a good option for you.

Pros: What could be better than machines making money for you when you’re not even there? Also, this is a good option if you’re from a more technical background and you want to move into finance. Since there’s analysis and programming, you can also exit to non-finance jobs more easily.

Cons: Financial crisis will present new challenges for trading algorithms; also, a lot of the work in actually creating the algorithms and sifting through data can be rather tedious.

Exit Opportunities

Not too much is different here vs. fixed income: you either stay in trading at an investment bank, or you move to a hedge fund or prop trading firm.

Or if trading is not for you, you move to a different industry.

If you haven’t been in the field too long then it’s possible to move over to investment banking or others in your bank – but if you start out a hedge fund or prop trading firm, your mobility is more limited.

All of the above is true for the same reason it’s true of fixed income: your skill set is more specialized than, say, an investment banker’s, and on paper most of what you do doesn’t seem relevant to other fields.

Coming Up Next

Sales & Trading vs. Investment Banking and some day-in-the-life stories.

About the Author

graduated from Stanford, worked in equity research and trading in Japan, and then started and sold his own prop trading firm in China. He then attended both Yonsei University in Korea and The Lauder Institute at Wharton, graduating with an MBA. He currently works as a Financial Analyst at Google in Tokyo, Japan. You can read an interview with him here.

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