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Upstairs v. Downstairs Debate

The following excerpt is from a live interchange between Tom Baldwin (written about in Jack Schwager’s Market Wizards) and Peter Borish (former number 2 man for Paul Tudor Jones).

P=Peter Borish, T=Tom Baldwin, M=Moderator

Peter Borish: Price makes news, not the other way around. A market is going to go where a market is going to go. The floor can not exist without the people upstairs, the upstairs can’t exist without the people downstairs. I must say that, in truth in advertising, I am Chairman of the Futures Industry Institute, but any day I would much rather trade through the floor, through an exchange. Forget clearing, forget settlement for a moment, in terms of simple execution, knowing that the price I’m going to get is going to be the best price. To this day, I’m still trying to figure out why it is so easy for me to buy the high and sell the low and not the other way around, but that is part of the business and I complain too. Don’t get me wrong, maybe I complain louder than some other people, but I accept the wounds that take place with that. That happens, but the floor gives you the better price, you know where you are getting filled and you get it back. Those not trading large size for example, if you want to go through the foreign exchange market or the interbank market you will know what I am talking about. So, I am a big fan of the way things are structured on the floor, and the more size that I want to trade, yes it is going to cost me a little bit more in terms of slippage, but that is a part of doing business, right? I can trade one lot and then play the bid v. the offer, but I want to trade a 1000 lots then obviously why should I ask the person on the other side to give me the same risk when I want to trade a 1000 times larger, so I know what the cost of doing business is, but business is cheapest, most efficient and the best on the floor. The one other thing I should say is that Tom has all these business so he must have been pretty successful, so if I can be on the same side of his trade, rather than the other side, I’m probably in good shape.

Tom Baldwin: It’s nice to hear some one like Peter be so conciliatory to someone who trades on the floor of the CBOT. I wish most people had the perspective he has, which I agree with. A lot of people don’t understand floor trading. It is really a job of making a market. That job is to facilitate orders for managed futures and for people not speculating. But remember, the real basic reason for the business is hedging. That applies to people who don’t really care where price goes, they are just interested in transferring their risk. A need to make a market for those people, that is the core of the business. As a trader on the floor, what happens when you start to trade bigger size you have to develop some sort of speculative strategy otherwise you would not be able to trade the size Peter trades. You need to change your style, you can not be blind to every order that comes in the pit. That’s what I try to do and so I end up with a reputation of Baldwin is selling or Baldwin is buying. Making a market for T-bonds is my job. Everyday is different and you have to adapt your style.

Peter Borish: Tom, when you are down on the floor and you see all sorts of price activity taking place, for example tomorrow we know unemployment figures are coming out and the only thing we know for certain is there is going to be volatility after the number. Compare how you step up and provide that liquidity in the marketplace, somebody like me vs. what happens for the downstairs. Who makes the first more after a number comes out? Is it locals or somebody upstairs putting in an order to trade?

Tom Baldwin: With your example where the number is so important, it is usually a combination of both. Everybody knows what the effect of the number is going to be. So if it is way out of line, the people in the pit understand the market is going to go is the direction that it is out of line. The upstairs orders also come in at the same time. The object is to move the market as far as you can to a point where you buy or sell at that level, so there can be a two way trade. Nobody want’s to be the face plate on the train. There is no point in it.

Peter Borish: (Sarcastically) But, it opens @ 97. It says in the daily range that it’s from 97 to 98, how come after the number came out @ 97.04, I can’t filled @ 97.06? I want to buy a lot there!

Tom Baldwin: The reason you can’t is that is really not the market. At 7:29 am before the number comes out the market is at ‘x’ and then when the number comes out and its out of line, the actual market has a gap between where it eventually goes to and where it starts. And in between there is really nothing there because the market is now here. And most people are not accustomed to that jump and they are not aware that there is really nothing to trade there, unless it is by luck. i.e. there was resting order that happened to be there, doesn’t happen often. So you would never get filled at those prices. It would be very easy if when the number came out and you said gee that’s way out of line and it’s really bullish and I want to be long 1000 bonds, well the rest of the world is not stupid either and they see its out of line so they decide not to sell now. When it rallies a point then I’m going to sell it. Because that is where the market should go to based on that number. It’s like saying I wish I could buy 1000 bonds a point below market, but it’s not the market.

Peter Borish: If I had a stop in the pit and it gets filled far away it’s not like every single local in the pit happened to get a piece of that on the way up and as soon as I get filled it comes off 10 ticks?

Tom Baldwin: The nature of the game…

Peter Borish: …is to win.

Tom Baldwin: That’s right. What goes up must come down. Generally, as a market maker you trade with skepticism. Every body is tested on every order. Otherwise it would be too easy. No matter who it is, nobody is bigger than the market. Whatever they are going to do, you have to test a little bit. 10 ticks may not be too bad!

Peter Borish: Well…(both laughing) that’s easy for you to say. If you know a period is going to be volatile, should I use straight stops because I might never get filled if I use a stop and a limit or should I use a limit order. Should I do the panicking or should I let my broker do the panicking? Myself, I like to panic!

Tom Baldwin: That is the key thing, it’s emotional. The bond market, because of the liquidity and way it trades, if you are unemotional and you pick your right spots with timing you’ll be able to execute your trades at better prices than if you are emotional about it. You would then save the kind of money you are talking about. I’ve always found that when I’m in a losing trade, I would like to get out but I know the liquidity isn’t there, it’s not offered, nobody want’s to take the other side of the trade to let me out. So I need to pick my spot where I’m going to get out of my trade rather than just throw up my hands, I can’t take it anymore and bid 4,5,6,7,8 and then throw up my hands and take my loss Every time I ever done that the market went my way then immediately went down the other way. I often found that by staying calm and getting out with resolve, continually buying it with patience, which is hard to do when you are losing money. Its not that this is easy.

Moderator: I’d like to quote Tom from an article, dealing with pain thresholds are very difficult, that’s why the world developed systems. You try to develop a computerized system that doesn’t have feelings and you don’t have to deal with emotion. You can blame the system and make adjustments.’ Peter, how do you feel about that?

Peter Borish: As a systems developer…(laughter, Peter’s forte is system developing) and as a systems trader I think that works fine while you are developing a system, but the minute you put your own money into a system and you suffer a draw down. The fact of the matter is, you try to develop systems, but the real world is not a computer. i.e. your system may assume that if I had a stop at a certain price that I could have or I can get filled tomorrow on the unemployment date. You have to build into your system development those type of real world contingencies that take place because when you look back historically, you’ll see a long large bar on that day and it will have a high and a low. Any system software out there will make the assumption you could have gotten filled there in the course of the day in that range. The technology is not there whereby you can replicate and build a perfect system. But it goes a long way toward eliminating emotion. I gave a talk last week, where I used the quote, I’m an economist, I’m trained not to have any emotion and most of the people at my office will remind me of that quote if I get a little emotional over a position. No, you can’t eliminate emotion totally even from systems development. It may be more emotional to be a systems trader because Tom can actually do something about it. He can say, ‘I don’t like this, I am getting out of my position’. If you are a systems trader you have to sit there and take it.

Moderator: Are you saying a discretionary trader upstairs has an advantage?

Peter Borish: Compared to?

Moderator: A systematic trader upstairs.

Peter Borish: When things are going well, nothing beats a system because a discretionary trader will beat himself because he’ll think it can’t go this far, it can’t go any further. A system forces you to make the hard trade and keeps you in the trade. What happen is of course when it ends, and its not a hard trade anymore, but the wrong trade. That’s when the discretionary trader comes in. That’s what makes a market. Sometimes a discretionary trader has an advantage, sometimes a local, and sometimes the systems trader has the advantage. And then there are those days when we all get killed.

Moderator: If you take two successful traders, as you both are, how would both distinguish between your skills and risk taking aptitude?

Peter Borish: Tom mentioned something earlier about luck. I think its much better to be lucky than good. And your best combination is to be both good and lucky. A lot of our skill sets are really much the same. A discipline to your approach, whether systematic, discretionary, or local approach and sticking with that approach. A discretionary trader gets in trouble when he tries to be a system because he got out of a trade too early, he says, ‘I’m just going to hang on and follow this moving average’. And the system trader gets in trouble when he says, ‘That’s it, I know it is the top I’m going to get out here and override my system’. ‘I know I shouldn’t do it, but this time is right. And I’m sure the local trader will go through the same type of problem when he says, ‘You know what the market is not really going up, its just running these stops that I sold into and I’m going to hold onto my short position,’ and then all of a sudden you no longer are following your discipline.

Tom Baldwin: Systems trading is saying I can’t control myself so I have to have a system. My emotional makeup is going to fall apart when it gets pushed to the x point. Therefore, if I have a system I’ll be able to break through that barrier. I’m saying, you have to take responsibility and go through that barrier yourself. It is true that when you get to the wall it is all about yourself and it is an emotional thing, difficult for people to overcome, so they use systems as support. There are people, like me on the floor, who don’t necessarily do that.

Moderator: But, your upstairs business is systematic right?

Tom Baldwin: Right, because it is easier.

Moderator: Expand on that?

Tom Baldwin: Remember upstairs, your job is to make money. Downstairs, your job is not to lose money. The job downstairs is to be a market maker. Trading not to lose from the floor point of view you are going to do what you have to do to not lose money. That’s the goal. In doing that you end up making money because you are getting in positions that are the right way. If the initial trade is wrong and I lose money I don’t, like a CTA, go well OK I’m short 900 and its 5 ticks against me, I’m going to buy my 900, count up my losses and start over. What I do from a floor point of view is trade the position. That might be buying 3000 @ what ever price I can get out, carry the market with me and sell it higher. You have a lot of gunpowder when you are wrong. You are going to make the market move, people who are wrong generally move markets. You don’t have that kind of liquidity with that size. So, what’s the point of me just getting out of my position. I might as well, if I’m going to buy 900, I might as well buy all I can, it’s only going to be probably 1500 and in the process its going to move the market and then I’ll make money on what I end up being long and then if I get reinforced by the rest of the world and they continue to buy it, well then I’ll continue to buy it. And then it will keep going. So, what started out being a losing proposition, short 900 and 5 ticks against me, turns out to be a big winner. From the floor point of view, its what you do with the trade when you get it, how you make money. Versus being upstairs where you tend to be more analytical with money management principles and systems because its more difficult to move the market in ways that I do. Unless of course you are someone like Peter or another major CTA who has a big position and then they decide to get out and go the other way. There exists that opportunity, but they need to trade and trade fast if they are going to move the market. Generally though they are not that type of CTA. They are more long term with set goals and their own way of doing it. Their method works for them. My way is to take advantage of everything all the time.

Peter Borish: Being upstairs, it is a helluva lot easier to lose money than to make it. So, maybe I should go downstairs!

Tom Baldwin: I would say that it is just different really. What I’m talking about is a job, consistency, everyday. The same thing over and over again. 9 out of 10 days I’m going to have a consistent track record. I don’t know how much money I’m going to make. I do not have goals for how much I want to make. I just take what the opportunity is there. Which is really dependent on the volume more than anything else.

Peter Borish: So you have to let me win every once in a while otherwise there would not be any volume, is that what keeps getting me to come back! You got to throw the dog a bone! (joking)

Tom Baldwin: Like you said before, the market is going to go where it is going to go. The market is never wrong. When you make the right trade its just a matter of timing. When you get in and when you get out will determine whether you make money. That’s where your responsible for your trade and your price execution. All I’m doing is facilitating that opportunity for you.

Moderator: Can you effectively combine systematic and discretionary trading?

Peter Borish: That would be nirvana I suppose. In systems development most people concentrate on getting into the market. Entry is easy and exit is a whole lot harder. To combine the two would be combining the entry capabilities of system with the exit capabilities of good discretionary trader. That’s really hard. It’s very hard to hold onto a position when it goes against you. You hope when you have a loss that it will come back for you, but when you have a gain, you are scared to death that gain will turn into a loss. Exit is hard. If you could figure out a way to combine the two, then you would have the best of both worlds.

Moderator: Do people on the floor really look at numbers in depth like GDP, unemployment?

Tom Baldwin: You look at the number and get the perspective. You have your opinion too. But, if Goldman Sachs is coming at you with 5000 bonds and they want to sell them and in your opinion it is going to go up, why fight it? It does not pay to fight it. Timing is critical.

Moderator: How aware are each of you of the big players in the market?

Peter Borish: I never know who is on the other side. If Tom has a big position or not a big position, who knows? I trade because I believe a market is going to go somewhere or I’m in trouble. In general, if I knew he had been very successful I would not want to be on the other side. I have no clue on the day to day who is on the other side of a particular trade.

Tom Baldwin: I would take trade based on liquidity of the market right at that moment. That kind of size, you have to understand is not that frequent. Somebody coming in with a block order to sell a 1000 contracts is not that frequent. These are not many who will take the other side. However, collectively there could be liquidity there to take it. You don’t ever know when you are in the pit [what’s behind a large order]. The president of the United States could have been shot, you don’t know. There could be a lot behind that first 1000 lot.

Peter Borish: (laughing) That’s Hillary!

Moderator: Tom, talk about the floor’s view of managed futures.

Tom Baldwin: I would say a lot of traders are still scared of managed futures. The power a major fund could have in a market such as soybeans is great. In the past, their type of trading in less liquid markets has been more about retail business where it was small orders generally, watch out for commercials, but they just wanted to make a market, buy sell and they did not have to employ any trading philosophies or techniques. The reason memberships were so expensive was because they made money just making a market without markets moving and having to really trade with the kind of technique we are talking about. So when managed futures came along those types of traders could not handle it. They were not able to. There has been a lag time for floor traders to develop the ability to handle the larger traders and provide that kind of liquidity. The bond market is one of the first to do it. In other markets that is not the case.

Moderator: How do you see differences of OTC vs. floor in for example currencies.

Peter Borish: Separating the currencies for a moment. The general rule of thumb is that I want to trade in the market that is most liquid that provides me the best size for the lowest bid/offer spread. Most of the time in the world that will be futures markets. In addition, the fact that one is going in and out, you are much more invisible in futures markets versus cash markets, unless you have delivery lines in the cash markets, you are often forced to get in and out with the same person. I’ll ask Tom, if you know that I bought 1000 contracts at 9711 and all of sudden its trading 9616 and I call you up on the phone what do you think I’m going to be doing?

Tom Baldwin: Liquidating.

Peter Borish: And, wouldn’t you love to know that?

Tom Baldwin: I already do! (laughter)

Peter Borish: I know you do (laughing). But the average person on the floor doesn’t [and there is that increased invisibility compared to cash]. The currency market is a matter of what came first, the chicken or the egg. In every other market the futures markets have developed and with that development of the futures markets has enabled the underlying growth of the cash market, narrow bid/offer spreads, and everything else. One thing I can say for certain, there are not that many kinds of soybeans, cows or what ever, but governments throughout the world are going to continue to issue debt and there will be the development of more debt futures markets and I believe any government that wants to see its capital structure grow needs to develop a full fledged futures market. The currencies are different because they came first. The banks were there and transactions were related. It is the only true 24 hour market. I would take the currencies and put them in a little different area. But, there is no question I’d rather be doing something in the futures markets because of it protection and its invisibility and liquidity in the pit.

Peter Borish: Tom, let me ask a silly question. The bond market can’t balance the laws of supply and demand because we know there is always going to be additional supply in the bond market, right? Does anybody believe we will ever have a balanced budget in the US? Never mind Italy or some of the other countries. Should not bonds continue to go down forever?

Tom Baldwin: Well, I think its only based on the fact that somebody believes the United States government is going to pay it off. That is the integrity of the whole system. But, philosophically, I think you are accurate. And, if you look at it in a big scale, a global scale when you look at China, I think I read a statistic that we are going to have to provide 3 times the world’s GNP in debt to develop just China. You would have to say interest rates should go up a lot higher. They are going to have to borrow a lot of money and then trust that somebody is going to pay it back. That is what scares me from a personal level.

Tom Baldwin: Floor traders, in the bond market specifically, a bear market in bond market is equivalent to a bull market in any other market. When the bond market declines, the volume increases dramatically, with the increase in volume, the opportunity is much greater. From the bid/ask point of view, to the market movement point of view, when you combine these two like we’ve had this year in the bond market for a floor trader, trading with the philosophy of making a market trade not to lose, you have phenomenal opportunity. From the CTA/CPO point of view, the major shortage in this business is qualified CTAs, CTAs that are traders. You have to look at it, we had a 26 point move in the bond market. How did you lose money? They all have systems. At what point why did you not sell it? What do you need?

Peter Borish: I had a long term system that was long since October 1987, OK! (laughing)

Tom Baldwin: That’s a great point. Because the major short coming I see for CTAs and systems traders is an exit strategy. Everybody has initiation strategies but very few CTAs have developed strategies of exiting, trading around and out of their position, that I have seen. It’s an obvious place to concentrate your efforts! My observations of this year in particular, more CTAs have been investors rather than pure traders, at least in the bond market.

Moderator: Tom, could you do what you did upstairs?

Tom Baldwin: It is difficult. I think so. I have developed a system with discretion. Where I concentrated has been on exit strategies. The industry is much more business like. You have to mange it like a business, with money management and risk management principles and trading techniques, otherwise people don’t give you their money. The people that are going to give money to manage have different criteria as they are not, I have found, interested in 100% performance. They are interested in low volatility and steady consistent trading. I think that provides a lot more opportunity. It isn’t like that the industry that is supplying the money is looking for the best performing CTA, because he is too scary, his volatility and risk look too high, where as the low volatility CTA who makes 15% a year they are in love with.

Moderator: If Tudor was looking to expand its traders, where would you look for talent? Would they come from dealing desks of banks floor?

Peter Borish: I’ll beg to history, Paul Jones came from the floor. It depends on what type of trader you want to have. I believe that there are really very few traders out there. Most people are in the business because they like the reward of the business, which is money, but they do not want to do everything they need to do to become successful traders and be that system developers or discretionary traders and most people who think that if they are sitting on a desk and they are a market maker for a bank or they are a broker filing paper on the floor doesn’t make them a trader. So, I think you have to scour the entire universe. The people I think who can make consistent amounts of money are the people that worry about protecting themselves, the upside will take care of itself, you have to play good defense. This is Chicago football under Mike Ditka. No turnovers, 3 yards, and a cloud of dust. That’s the type of trader we want to have, not the trader who will have 1500 points in the S&P’s and risk it all. If you want to that in my opinion, you are better off going to a casino.

Moderator: There is no one common characteristic to traders?

Peter Borish: No, we all look for that. We work really hard because we want to look for the Holy Grail of system that will enable us to go to beach everyday and make money, that’s everybody’s dream. Or you want to look for the perfect discretionary trader to give money to so you can go to the beach and make money. But, I don’t think either one exists.

Peter Borish: As an economist, what makes this business so appealing for someone who is starting out, is that most businesses where there is a lot of money, the barrier to entry is high. In this business, the barrier to entry is relatively low and it is a very level playing field in the sense that if you have some creativity, imagination, discipline, or approach, you can enter and try that in the market and then there is no limit to your success and that is one of the beauties of this business.

Moderator: Tom, you have said you love to trade and would do this for a lot less money, do you really believe that?

Tom Baldwin: Yes I do. I never anticipated or dreamed or even knew it was possible to accomplish trading wise what I have accomplished. For me it was the love of trading that has taken me to where I am today. That was made possible by the US government and their debt, managed futures and the increase of volume. I could not have done it without all the other components being there. In the process of that happening, I’ve been able to make a lot of money. But the trading business is what I love, not the rewards. I could not tell you during the day whether I had made 200 or 300 hundred thousand or lost it. I could tell you that I thought I was up or down, but not specifics.

Moderator: Is that attitude the same for upstairs, Peter?

Peter Borish: (laughing) I know at 4:16 (NY time), the minute S&P’s close and the settlement price clicks up, I have a pretty good idea. That’s going to affect decisions because I am upstairs, I need to make portfolio decisions, I need to manage my risk and my volatility. I need to be aware of that. That’s one of the big differences from trading for yourself, whether upstairs or downstairs, and customers. What Tom has basically said, is that customers suffer from money illusion. If I end 15% on the year, that’s great, but the issue is if I was up 25% at one point, and ended up around 15%, it is a lot different that if I make 1% a month compounded. It is a different ball game.

Tom Baldwin: If you have the philosophy that I do, it enables you to do things you might not otherwise do. The bond market for example, provides a lot of opportunities, it does things that nobody would have dreamed it would do, with freedom you are able to take advantage of it because you are not stuck in the money part of it, you are into the trading of it and the enjoyment of trading versus the fear of the money.

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