The Gateway to Algorithmic and Automated Trading

Hiring Mr Wrong

Published in Automated Trader Magazine Issue 17 Q2 2010

Automation has obviously changed capital markets dramatically, but one area it has had more impact than most is FX options. With run of the mill market making con- ducted automatically by pricing engines, the trader skills required on an FX options desk bear little resemblance to those needed just a few years ago. Martin Gymer, CEO of FX option recruitment specialist Marshall Whitney, itemises those skills and the best way to evaluate them.

Martin Gymer

Martin Gymer

Watching a child playing on an X Box with complete control and dexterity makes one realise that in commoditised FX option products gaming skills are now more essential than 'trading feel skills'. Yet detecting those skills prior to recruiting a trader into this automated environment is not easy; hard enough for a head of desk with other things to worry about, and completely impossible for a generic head-hunter.

Even prior to the automation of FX option desks these mis-recruitment risks were substantial. The wrong trader could cost you significant money with just a handful of trades, but now the stakes are higher - much higher. In a highly automated environment the trader without the skill to properly maintain a vol surface can inflict massive damage in a very short space of time. Counterparties' automated arb engines will quickly spot the error and flood you with trades to exploit it. If your FX options franchise isn't to become swiftly and terminally disenfranchised, you need a means of quickly spotting and hiring traders with the right skills.

“Funnily enough, he’s just outside and could start immediately”

"Funnily enough, he's just outside and could start immediately"

Key skills

These days, the errors that cost big money in FX options are more likely to come from 'fat fingers', poorly updated volatilities or mispriced products, than poor market calls. Volume, Volume, Volume is the key, with speed of turnover through thin client (browser) trading systems and electronic platforms being the focus. Franchises have been built that require little "conventional" trader skills but instead need a trader capable of acting as an efficient overseer and watchman of these money printing machines.

Haemorrhage or bleed of profitability is the key; this can be compared to a bucket of water full of holes. The trader's job is to plug up enough of the holes to ensure there are sufficient profits left at the end of the day. Two recent examples where a trader with the wrong skills blew it:

  • A major investment bank ended up with the skew (the difference between symmetrical puts and calls) entered into its system the wrong way round, plusses instead of minuses. As the bank was providing liquidity to professional trading operations, this error was swiftly and expensively punished.
  • A buyside firm spotted an outdated point on the market maker's FX vol surface that gave rise to a major arb opportunity. In a fit of charity, the buyside firm called up the bank market maker to point out the error, but the warning was ignored, and was consequently arbed off the pitch.

A good technical knowledge of financial products backed by appropriate qualifications is only the starting point; a successful practical apprenticeship that includes periods of market stress is also needed. This combination is essential to ensure that the trader will have the right skill set to run a profitable book under pressure in an intuitive manner. In practice, this is frequently lacking at the most basic level. For example, in 20+ years of providing FX options training - both on the trading desk and in classroom situations - I have found only a handful of delegates among thousands that have been able to instantly and lucidly explain the relationship between the price of an option and time. (Even though this relationship is highlighted in every option model studied at college/university.)

Square hole, exploding peg

Square hole, exploding peg

How has this changed?

In the past a network existed (a sort of "manual Facebook") where traders interacted via social hubs provided by brokers or associations. Face to face activity meant that traders could talk openly about business (promote themselves) but more importantly they would be accounted for in their relationship to other market participants. With the advent of electronic trading these relationship and ethical reciprocation practices are no longer necessary. The demise of this community created a void between the institutions so no network prevails. As such, understanding the profile of market participants is understood by a few elite traders, their counterparties and intermediaries. This makes it extremely difficult for people outside the 'know' to have the inside track on the good, the bad and the ugly.

Traders need to have traded and not just baby sat money making machines. Trading pro-actively to put on and accept risk. Risk is key in all markets and all traders must understand and have traded risk; most importantly to have suffered the pain of risk and have learnt from this process. These tuition fees have to be paid to the market before you can be considered a trader. With automation, particularly in derivatives, traders and businesses are systems-dependent and market making is now automated. Managing the residual risks arising from this automated process is now the key to a successful FX options franchise.

In a large portfolio it is impossible to know when a trader could have maximised his/her profitability or how much 'value added' a trader gives to a franchise. In some cases profit and loss reports may take hours to run and P and L can remain un-reconciled for days or even months.

The yardstick for measuring performance is also unclear; separating the trader's personal P & L contribution from that automatically conferred by the franchise and corporate/customer flow has always been a grey area. It is an even more contentious issue today with complex portfolios, systems and models, which may or may not be accurate and thus obscure the true skill of the trader. An individual's true trading skills may therefore be unknown - even within tightly knit trading environments.

How do you recruit a good 'un?

So how can a conventional head-hunter discriminate between 'good' and 'bad' traders? To the expert eye watching a trading floor, it is immediately obvious who the expert traders are from the way they conduct themselves in conversations and interaction with their peers.

However, head-hunters lack the specialist skills to conduct this sort of informed scrutiny; it requires someone who has been in the industry for many years to spot the good from the bad. When faced with a class room full of students sitting at desks, who could spot the potential Tiger Woods or Roger Federer? But to an experienced athlete witnessing a practice swing, the star is immediately apparent.

"A poor trader cannot hide from a good one..."

The equivalent warm up process can be observed in traders. Not in a trading environment, but through deep, detailed interviews with a practitioner who has held these positions and knows the "animal" in front of him/her. The confidence that comes with a technical understanding of products and risk and how to control it will emerge during this process. A poor trader cannot hide from a good one; small discrepancies and inadequacies in their answers, approach and understanding will reveal that they are not what they claim. An in depth interview that includes multiple technical questions specific to the product area and product risk that is conducted by an experienced practitioner will reveal the true nature of the beast.

New approach needed

Head-hunters provide a saving in shortening the time it takes to find a candidate and providing a conduit to approach other banks and institutions without direct responsibility. This model may be perfect for filling 'cookie cutter' positions, but for jobs at the coal face of today's automated FX options businesses it is likely to backfire spectacularly.

Identifying those who can understand, control and execute risk under pressure at high speed on a trading desk requires detailed peer to peer analysis. The key point is not reducing the timeline of the recruitment process, but ensuring that the candidate is the best possible match for the business. In a perfect world, all head-hunters would have the necessary skills and structural knowledge of the industry to deliver this; in practice hardly any do. The Texan fire fighter Red Adair put it well:

"If you think it's expensive to hire a professional to do the job, wait until you hire an amateur."

...which applies to recruiters and traders alike…