Games are being played with the new electronic trading that you might not hear about. Here is something that happened this week.

A layup trade is when an option, or options, are packaged and traded along with futures. For example, buying a synthetic put would require the simultaneous purchase of a call option of the same strike price and expiration as the put, along with the sale of a futures. This is because a long put is equal to a long call and short futures. Just as a long futures positions is equal to a long call and short put position in the same strike. I realize that some of you may not fully understand that, but if you break it down it’s true, but let me go on. Each day we see more and more lay up transactions. Often transaction of this sort might be executed delta neutral. In other words the offsetting futures portion has an equal but opposite equivalent to the options side.

This week an RFQ, or request for quote, was submitted on the electronic platform, asking for a fence quote using a delta of 37%. Again delta is the term used to describe how much the option position acts like a futures. In this case it meant that each options fence, (a fence or collar, is an option position where you buy a put, and sell a call, or vice versa) acted like 0.37 of a futures contract. In order for the position to be exactly neutral, you would need to trade 37 futures against every 100 fences. Got it?

Well, the RFQ also wanted to use a futures price that was distant from current market, with me so far? In doing so, a responding market maker would price the option fence accordingly, using the value of the fence based upon that far away underlying futures price. When the market maker quote was made, the requester, sold only 1 fence. Now that doesn’t sound too bad, but how do you trade 0.37 of a futures? Not even the computer can do that, so the ICE platform adjusts the trade rounding off the futures. Had the delta been .55 or 55%, then it would have rounded up to 1 futures, but since it was .37, or 37% it rounded down to zero, or no futures. Bottom line the RFQ used the market maker in the pit and quickly made a hefty profit of about $1,500.

Several pit brokers participated from what I understand, each getting used. However, many complained and ICE performed its duty. The result was that most trades involved got canceled, but not all. I ask you, is this system fair? When someone intentionally places orders in an effort to play games what kind of market do we now have?

The market is crazy today. The S&P is up over 40 points. Did anyone see the dried ink on the paperwork saying the Greece bailout was done? Honestly, I do not trust what is presently going on but am happy the market has rallied from the bottom. Financial stocks are leading the way which has been a long time coming. Hopefully, BOA can get out of the penny stock area and shoot upward. Those who were caught short had to cover today which could be the reason for the rise on the last 20 points halfway through the day.

I’ve been asked to provide things the average trader might not consider. Here is one.

We all know about charts. Charts are important tools that show where the market has been and where it is. Technical analysis attempts to use charts of past behavior in an effort to predict where prices might be headed. They use a variety of approaches, studying chart patterns and simple as well as sophisticated mathematical models in their efforts. Fundamental traders study supply and demand and try and predict price trends based on perceived changes. But here is another factor that ought to be considered, market psychology.

What do I mean by market psychology? It is an effort to appreciate and understand the attitude of the participants in a particular market. Sometimes surveys are taken. For example, a sample of market players may be approached to provide their view, are they bullish, bearish or neutral towards a particular market? Then that information is quantified to provide an understanding of a markets expectation. Often a simple poll is taken and a consensus of opinions published. We most frequently see this done by news organizations in advance of a fundamental report being issued, a crop number, or a government economic statistic. But what about asking a group of traders?

First of all, are those asked liable to tell you the truth regarding their market view? Some savvy players have been known to play liars poker. So taking a reliable sample is critical.

I have been in this business for many years. Much of my time has been spent on the trading floor. In all my years in the business, I have come to the conclusion that option traders are smart. They are smarter than the old guard of futures traders that used to populate the trading floor. And I think they are smarter than the average trader. So I always like to perform a little survey among option traders as to their opinion. You can’t do this easily, unless you know the people. Ask your broker, which way is the pit leaning? He may not know, but if he uses the floor for execution, that is something a good floor broker can tell you.

Unintended results….Occupy Wall Street is massing in an effort to protest the “Fat Cats,” on Wall Street, but having spent my career on Wall Street I see things from a different perspective than those protesting. I see massive layoffs and good people put out of work as unintended consequences, from fundamental changes in Wall Street. Much of this the result of legislation that enabled the industry to change. Those losing their jobs aren’t the “Fat Cats,” they are regular people like me, and maybe like you, but doubtfully any of those protesting. Government bailouts are one thing, and if you ask me, most are only political pay backs, which have always been around. What I see different is a fundamental change in the role and function of Wall Street and these changes have bee promoted by legislators.

Time once was that a stock was a method for a company to raise capital for expansion, now its more a method of cashing in. Wall Street was once instrumental in putting together deals to assist funding companies issuing stock by finding investors willing to own stock in that company. That was a principal function of Wall Street. The investors sought price appreciation and dividends from owning the stock. The exchange’s principle purpose was to provide a mechanism for price discovery, so value was determined by the investing public in an auction. Now Wall Street is more a of an electronic card game, with the deck being reshuffled after each hand is played. Stocks are traded back and forth, and more often than not traded and not held. Government has enabled this card game to grow by sanctioning it indirectly which I see as an unintended consequence of fundamental changes. High on that list is that exchanges are now public companies.

As publicly held companies, the exchanges are now more interested seeing that their shareholders benefit. Nothing wrong with that motive, that is how successful businesses are run, for a profit. However, exchanges were not always publicly held companies. It was only in the last decade that they changed through a process of de-mutualization,, (See this link for a fuller understanding: http://www.imf.org/external/pubs/cat/longres.cfm?sk=15889.0 ) and unfortunately that comes with numerous unintended consequences. In other words exchanges motives have changed. Exchanges today are more interested in increasing transaction volume rather than serving as a forum for price discovery.

In commodities, numerous rule changes, since the introduction of electronic trading, have invited more speculation. That in turn has led to a rise in volatility as larger and more frequent price moves take place. Granted, the 24 hour news cycle plays a roll, but there are machines now trading with increasing frequency. Additionally, self contained, “black box,” algorithmic programs that feed on technical price moves which tends to further exacerbate price moves, have been invited to the table. In general, exchanges today do not serve the general public as well as they serve the volume, institutional traders who solely seek to use the market to generate profits. And here I thought electronic trading was to level the playing field….silly me.

Having spent the bulk of my career working to promote the use of exchange traded products for the purpose of hedging price risk, and in a forum where all players would have the opportunity for a level playing field, I have difficultly these days. I see how unintended consequences have resulted from the de-mutualization of the exchanges. Do those protesting? In an economy where politicians speak of creating jobs, I’ve seen the floor population drop from 2,700 to fewer than 270. These were good paying jobs that are now gone.

The market is being tested and large hedge funds and buyers are capitalizing on the recent decline. I suggest not being a sucker here because the downside could be coming once again. This being said, I think it is wise to follow the trend upward for the short term. The reversals we have seen over the past day or two show that no one has a clue what is going in Europe. Also, the experts have no idea on how bad this could affect the U.S. Fact, consumers are scared. Fact, companies are not hiring and are scared. Fact, the government has done nothing to find people jobs. Greece should be left to default and the dominos should fall along with it. Throwing money at everything is just hurting the FX market.