One of the most exciting careers in finance is being a trader. Since the values of financial securities can fluctuate wildly, profitability in a trading account is always in flux. Traders are a bit of a different breed and are natural risk-takers. Some have become wildly successful (and rich).
But sometimes a trader takes too much risk so remaining a trader is sometimes another story. Trading can lead to major losses, even after making large gains. The dotcom crash and financial crisis are testaments to the risk. Prior to that, one rogue trader’s losses bankrupted one of England’s oldest banks, Barings Bank.
What is a Trader?
A trader is someone who buys and sells a good for profit. Today, trading refers to the buying or selling of stocks, bonds, derivatives, commodities and other financial securities. Traders can work for themselves or for an institution, such a fund or bank. The end goal is to buy low and sell high, creating a profit. If you purchase a stock at $5 and sell it a month later for $10, you’ve created a 100% return. Alternatively, if that same stock you bought for $5 went to $0, you’d have incurred a 100% loss.
An example of a speculative trader might be one who thinks the price of oil is going to go much higher over the next year. The trader buys oil futures contracts to try and capture the move up in prices. If oil prices go down, the trader will lose money.
Given the recent volatility in many markets, hedging is becoming increasingly popular. It’s important to understand the distinction between a trade for speculation or used as a hedge. Hedging is a strategy of mitigating risk of current investment exposure, not profit maximization. Common entities that hedge are farmers, transportation companies and banks.
Let’s say you’re an airline company that fears the price of oil (and consequently jet fuel which is a byproduct) will increase dramatically. If that scenario plays out, your company’s fuel costs would appreciate and jeopardize your solvency. So you try and hedge this risk. You, or a contact you have at an investment bank, would buy jet fuel futures contracts which will increase in value if oil and jet fuel prices increase. The strategy is that this increase will offset (or hedge) the higher costs you’ll pay for fuel when running your airline.
Contrary to your forecast, let’s say the price of oil and jet fuel actually drops severely. The company would have been better off, all else equal, without the hedge since the airlines net costs would have come way down by natural market forces. In our example, the costs did come down but were offset by losses in the jet fuel contracts they purchased. This is known as opportunity risk, referring to the fact that you may have benefited more without the hedge. This scenario occurred for many airlines in 2008 when oil dropped from a price of about $147 to a low of $33, a loss of roughly 78% in six months.
What are the Different Types of Traders?
‘Trader’ is a bit of a catch-all term for all related the several different types of traders. Here are a few different types.
Proprietary traders or “prop” traders put their firms own capital at risk when then trading. This is different from a hedge fund uses primarily outsider investor’s money. In the wake of financial crisis, many financial firms that used to trade large positions were reclassified as bank holding companies after the bailouts. With increased regulation, including Dodd-Frank, firms were required to scale back their operations and limit speculation. With risk managers breathing down their necks and less capital to trade, many prop traders have jumped ship for the buy-side where their risk-taking abilities (and compensation) aren’t as constrained.
Hedge fund traders
Some traders work for a hedge fund. Hedge funds are primarily funded by other investor’s capital. These investors can withdraw their money whenever, depending on a lock-up agreement. This can cause challenges for hedge fund traders and curtail a strategy that’s been implemented. Hedge fund traders and managers make headlines and appear in the media often. People follow this industry closely because hedge fund traders are the ones really swinging for the fences in today’s markets.
Day trading was all the rage in the dotcom days of the late 1990s and never returned to its former height. Day traders buy and sell securities throughout the day but at end the day are ‘flat’ (with no outstanding positions). Whatever is bought is sold by the end of the day so no positions are carried on the books overnight. It wasn’t uncommon for true day traders to make hundreds of trades in a single day.
Today, day traders are referred to as ‘active’ traders (day trading can have a somewhat negative connotation). Most active traders don’t only hold positions just intraday, but some do. Becoming an active trader is easier than ever. Dozens of online trading platforms commissions next to nothing and allow you trade any security or asset class imaginable. The level of news, quote depth and analytics that are available basically free, used to cost hundreds or thousands of dollars just a decade or two ago. But just because the costs have come down and your investment choices have increased doesn’t make trading any easier.
A ‘market maker’ a class of trader that works for a broker dealer, tasked with maintaining an orderly market for a security. Making a market means offering to buy from or sell a security to the public at all times time at a certain price. They do this dynamically by changing their bid and ask quotes. Market makers may have dozens of stocks in their ‘list’. The role is to create liquid market but also is for profit, similar to a specialist on the floor of a stock exchange. There are market makers for all actively traded securities, including stocks, bonds, options and ETFs (exchange traded funds).
The role between market maker and prop trader sometimes gets fuzzy and led to firms getting dragged before congressional hearings after the financial crisis. Sometimes the firm might have a buy recommendation on a stock to its clients but actually have a short position (betting the price will go lower) by the firm’s market makers. This is obviously a conflict of interest that is difficult to solve, especially in volatile markets.
What are the Required Skills and Credentials of a Trader?
There are some qualifications and licenses a trader must have when working for a broker-dealer. Many traders have to pass the Series 55 exam, the Series 7 and possibly others depending on their interaction with public order flow. Individual, active traders who work completely for themselves won’t have to obtain licenses but may need to provide documentation in order to be allowed to trade riskier strategies on their online platform.
Networking is an important skill for trading people don’t consider. All trades need a counterparty, someone on the other side either buying what you’re selling or vice versa. For less liquid securities, there may not be a quoted price available to the public. Knowing who to call to get a trade done (at a fair price) is essential.
Maybe the most important of all is self-control. The ability to keep your emotions in check is so important in trading. You must be able to distinguish between unwarranted hype and undue panic.
What is the Compensation for Traders?
Maybe no compensation in financial careers varies as much as for a trader, since the bulk of pay often comes as a bonus. Payscale reports a median compensation for traders of about $57,000.¹ Glassdoor tallied the national average for traders at $91,730 which may be accurate taking into account bonuses.² On the higher end, the bonus can be multiples more than the salary.
Prop traders compensation probably varies the most. This is even more so than at a hedge fund because a hedge fund will still have the management fee it charges investors to fall back on (even in a losing year). According to Michael Karp of a New York recruiter Options Group in a 2012 interview with Bloomberg News, hedge funds are offering experienced traders (managing director level) salaries of about $200,000 to $250,000 plus bonuses.³
How do I Become a Trader?
The competition for trading jobs is high so to be hired as a trader today, you’ll need a bachelor’s degree and a master’s degree is preferred.
Landing a job as a trader isn’t easy and it helps to know someone. Use your contacts of people in the industry. Get to know some traders however you can, even if their firm isn’t hiring at this time. Attend industry events or ‘street parties’ (lingo for Wall Street parties) even if you aren’t yet in the field. There are several trade industry events you can try and get into; one of the most well-known is the STAANY conference in New York City.
It’s also important to notice the trends in the trading community. Regulation is likely to put pressure on staffing at traditional wirehouses while buy-side entities like hedge funds and asset managers are seeing their assets under management on the rise. Data from Eurekahedge indicates that hedge fund assets in North America have grown over 25% just since the financial crisis. Hedge fund assets stood at $1.19 trillion at the end of 2007 (right before the financial crisis) to $1.49 by the end of August 2015.⁴ You’ll want to focus your efforts on the areas that are growing (and consequently hiring).
Nothing beats experience. A long track record and a good reputation can open many doors for traders. This can eventually lead to you starting your own hedge fund, which is often the next step up for a trader.