Getting in some snorkeling today, my mind went back 14 years and 179 degrees of longitude to the first pit I worked around at KCBT as the market is as great an ecosystem as the reefs I spent the day observing. My favorite 'market' book of all time, Education of a Speculator, has a excellent chapter on market ecology and refers to floor traders as the decomposers which is certainly apt as they break down the bigger pieces of market action. In particular, the day brought to mind market niches and Darwinism which I first observed at KCBT and then most other trading pits on how the mechanics of the trading pits often worked. The Charlie D. video I uploaded a while back gave the general basics of pit mechanics in terms of spreading both inter and intra contract trading but didn't explain some parts fully.
When I started at KCBT, one veteran trader stood out as a guy who was an absolute trading maniac because anytime a broker called out for a market or bid/offered, he instantly quoted the other side ready to make a market and trade. Charlie D. referred to a lot of locals as "scalper-beggars" and whenever I hear that term it brings that one particular KC trader to mind because he even had the physical actions down of getting in the brokers face from a step below w/his hands in their face and repeating his market every time the broker opened his mouth hoping to get the broker to go up/down on price. Here's what it sounded like:
Broker - "Five bid Red Sep"
Trader - "AT FIVE HALF!"
Broker - "Five bid"
Trader - "AT FIVE HALF!"
Broker - "Five quarter bid Red Sep"
Trader - "AT FIVE HALF!"
Broker - "Buy 'em at five half"
And the trader would do that all day everyday, while not successful every time it was enough to make it worthwhile. All the while I had no clue what he was making his trading decisions on and my guess was that it was just gut instinct but he was just basing his decisions upon simple arbitrage.
When I started to get trained to trade in Chicago, the first thing one of my mentors did was give me a stack of flash cards that I was to learn the basics of spreading. The flash cards consisted of various spreads or outright contracts of the same commodity which I would have to quote the 'missing' market in. If I knew the market in one outright contract of the two legged spread and the market of the spread then I can quote the market in the other outright contract. For instance, a sample card (always quoting spread w/front month first) would read:
March 50 bid/50.5 offered
March/June spread 2 bid/2.5 offered
What's the market in June?
On the back the card would have the correct answer for me to check to see if I got it right. In this instance I could be 47.5 bid in June and offered at 48.5 because (assuming all markets had decent size to lean on) if I bought 47.5s then I could buy the 2.5s in the spread and that'd get me long the 50s in March (selling out/scratching the June) and vice versa if I sold the 48.5s in June then I could sell the 2 bid in the spread (buying back/scratching the June) and be short the 50.5s in March. That was about the most elementary flash card given as they went on to include more complex spreads but the idea remained the same, just get the math to equal. As Charlie D. said, getting the trade is more than half the battle and this was one way to get trades. This also feeds into a larger discussion on optionality in the market but I'm not gonna go there today.
Once I realized something this simple was all a lot of pit traders were doing, I was totally shocked.
The scale is obviously limited to do something as basic as market making based upon where spreads were trading but it's something that plenty of people did to earn a living in the pit which didn't require any deep thinking, overnight positions or even risk for the most part. Now those days are gone when such arbitrage was possible as the computers made the market so efficient that a free tick is virtually impossible to come by. When it was inefficient in the past, sometimes the market was so far out of line it is mind boggling by modern standards. A former CBOT Chairman I remember was quoted in two separate interviews that he once got a grain trade back in the 1960s something like 15 cents though the spread....fifteen cents of pure arbitrage!
One funny story I remember while being a new trader in the pit was wanting to buy a spread, say 2.5s, as that was a level I came up with through my own analysis. Looking around the pit there was a veteran trader who was screaming his lungs out to sell 2.5s so I thought to myself, "hmmmm, that guy has apparently been down here a long time and if he's 2.5 offer then it's probably not a good idea to buy those." Well, the two legs of the spread flipped and the spread turned 2.5 bid without me buying any then rallied the rest of the day. Even though I knew that many trader's only strategy was to attempt arbitrage, it didn't sink in until that moment and I realized that was all that veteran (and the scalp-beggar in KC) was ever doing.