You, or someone you know, may dream of becoming a trader. However, there is a big gap between the job's prestigious image and reality. We can clear up some of the questions surrounding this investment banking position. How does one become a trader? What is the trader's role? What is the job like on a daily basis?
The trader's job
To understand the trader's job, we first need to understand the role of the trading room. In providing its basic disintermediation services, a bank makes its expertise available free of charge to its clients. Then how do they turn a profit? Banks use the same expertise developed serving clients to their own benefit in trading for their own accounts. This activity generates its gains from the volatility of financial assets, simply referred to as risk. By taking risk, the bank registers a gain or a loss. Therein lies the role of the trader. He has two main functions, which may be exercised simultaneously: risk management and speculation. These two roles exist throughout the profession and, depending on their relative importance, the trader's job title may vary.
A trading room is usually organised vertically and horizontally, like a twin matrix.
The vertical classification separates the traded securities. There are five types of risk, referred to as underlying. These are the underlyings:
Credit risk refers to the risk of an enterprise or of a government defaulting on its debt. The traded security is similar to an insurance policy that protects its holder from potential default, i.e. from an event that could cause the enterprise or government to be unable to meet its debt repayment commitments. The purchaser of this insurance coverage, thus, has a claim on the relevant company or government. The trader assigns a price to this insurance based on the risk entailed. For example, there is a greater likelihood that Russia will default than the United States, so the insurance on its debt costs more. The price of the insurance on a given issuer will also vary, according to economic and political conditions. In short, "credit quality" varies. The trader may take a gain or a loss, depending on the price at which the insurance was sold or purchased. These are the latest financial instruments on the market, and they are the fastest-growing and have the brightest future.
Fixed-income risk (reinvestment risk) stems from changes in interest rates set by central banks. If you borrow at 5% today for one year, and the central bank suddenly decides to lower its annual rates to 4%, you can re-lend your funds at no more than 4%. As such, you end up losing money. This is the second largest market in the world in terms of volume. A contract entailing a notional amount of several million dollars is not a problem. This is referred to as the fixed-income or debt market. Swaps and bonds are the main securities traded on this market. We mainly find financial engineers on this market, which is mathematically the most technical.
Equity risk: the most well known risk. It is related to business operations. This market is small, compared to the debt market. Equity transactions involving millions of dollars are typical.
Foreign exchange risk (Forex): the risk on currency exchange rates. This is the biggest market in the world, with daily trading volumes of $2 trillion traded daily and constantly growing.
Commodity risk: this is a smaller market than Forex and debt, but it is also growing fast. The risk relates to commodity prices.
Horizontally, the room is separated into four main branches, separating the functions between traders.
Two main categories distinguish the structured securities desk from that of the more basic products (swaps, equities, currencies) referred to as "plain vanilla" securities.
The market maker: working with basic products, such as spot (currency rates), cash equity and government bonds, the market maker simply responds to clients by quoting prices in two ways: a "bid" price at which he is willing to buy and an "asked" price at which he would sell. The positions held by the market maker are the result of deals he makes. He must always be careful to cover these positions as he tries to generate profits. However, the market maker is not supposed to speculate. He must work within the strict limitations of his positions. More often than not, new hires start in the position of market maker, which allows them to get to know the market while taking little risk.
The trader of plain vanilla securities: vanilla financial instruments generate the most revenue in the trading room. But these profits now represent just 60% of the total, and this share continues to decline, due to competition from structured securities. These products generate little, if any, revenues from bid-asked spreads and much more from speculation activities. For example, a €100 million swap deal may generate a profit of only €5,000. Speculation generates most of the profits. Will the price of gold rise or fall? Will the US Federal Reserve lift its rates at its next meeting? Revenues per trader vary considerably, depending on the activity. Reasons include: the currency in which the trader deals, the market, and region of the world in which he deals and, above all, whether or not the trader is a good speculator. This job does not necessarily require an advanced degree. More often than not, new recruits are 20 to 23 years of age, and have little or no experience but plenty of enthusiasm. The bank's seasoned professionals train them in their in-house methods.
The trader of structured products: structured products are currently the most popular financial instruments, and their profits have been rising in the last several years. These instruments often provide a complex profitability index of different vanilla products. The profits are made from the investment firm's spread or margin on the transaction. These margins can be substantial or even astronomical, because it is generally hard to estimate with certainty the price of these exotic products (since they usually do not yet exist) and it is impossible to hedge them fully (they are often issued by the unit). Structured product traders are pure risk managers: they do not engage in speculation because a single deal can bring in €500,000. This segment of activity often employs some of the investment firm's senior analysts as well as young graduates with a keen business sense in training to become analysts. In France, such trainee/interns typically have degrees from major engineering and business schools.
The proprietary trader (or prop trader) has carte blanche to speculate with the investment firm's funds on all markets. Unlike the market maker, he does not provide quotes to clients. With a high-risk job but one of the best paid in the world, the prop trader is paid a percentage of the profits. If the structured product trader generates €50 million per year, he must share the profits with the structuring, sales and research teams. The prop trader can easily make this amount but he does not have to share it with a team. He has a highly coveted position, but he stands out for his age in the trading room, since prop traders are among the most experienced. They have usually put in ten years in the trading room before assuming this post.
The trader thus manages his book with a tremendous amount of freedom. Prop traders are pure speculators. Vanilla product traders are in an in-between position, because a huge part of their profits stem from speculation. The job consists of offering quotes to clients, like market makers, and also of speculating on their market, which they know well. Generally, their speculative positions, which we can legitimately refer to as prop trading, exceed the volume of market maker positions by a factor of 5 to 100. Structured product traders also hold this intermediate position but mainly generate profits from market making (via the margins). Their prop trading positions are mainly secondary and, at times, they have none. The market maker has the least margin for manoeuvre.
Becoming a trader: what career path
Let's make one thing clear upfront: the hiring process for traders is highly competitive. French investment firms generally put more emphasis on university and business school diplomas and some emphasise them more than others. However, the world's largest banks are from the English-speaking world. For UK or US firms, university credentials count less, although that is not always the case (especially in those fairly frequent situations where employers learn to value the math skills of graduates from the top French schools).
It is hard for someone outside of Human Resources to size up the hiring criteria, but it is definitely an obstacle if you have not been through a major preparatory course or business school. The norm in France is a diploma from a top engineering school, followed up by a third year in finance or stochastic calculus.
Having said that, there are many modestly-sized investment banks and stock brokers, whose profits do not mount into the hundreds of millions of euros per trader, but which offer people with less sterling diplomas plenty of opportunities. It is also important to note that university credentials often matter less than the trader's initiative and ability to understand the market and predict its behaviour (as the English-speaking banks well know). As such, if someone performs well, even in a small company, he has every chance of being recognised and eventually handling more substantial sums. This type of individual success is far from isolated. US investment firms are full of self-made prop traders. However, youth is crucial for those who take the non-diploma path to success. The earlier a trader begins to make money, the better his chances for dealing with large funds. The successful trader enjoys real independence from the firm, since he who makes a name for himself on the trading floor also shines on the market itself.
And yet, there remains another well-trodden path for making it on the trading floor, including those of the biggest banks. A person with exceptional know-how that is needed on the floor is worth real money. Understanding the Koranic laws relating to investments or speaking Arabic are outstanding cases in point.
For those who lack these skills, there remain two paths. The first is to become an assistant trader. In reality, there is no such job as assistant trader. This is really more of a catch-all job title meant to attract interns. The assistant trader is generally responsible for verifying deals and working out problems with the back-office when he has a doubt. He also estimates the P&L (profit & loss statement) and verifies its main items, updates the pricers in the morning, answers the phone, updates the spread sheets for pricing and the calculation of present or historic risk, monitors risks and positions, acts as liaison with research and helps provide quotes on big trading days.
In principle, the assistant trader should go on to become a trader (except in the case of certain banks). He is unable to get hired into the position straight off, but the university credentials required of him, though slightly less stringent, are fairly comparable. He is in a sort of halfway house because the firm wants to put him through a trial period, be it long or short, under real operating conditions. But that does not change the basic reality of his intermediate position. The essential point is that the interns understand that they are being trained to become traders. The purpose of the job is for the intern to work his way into trading. He is thus allowed a measure of freedom including contact and job rotations with traders from other desks.
The second way to become a trader is via the middle and back offices or risk management, but the situation is different here. The diploma requirements are more easily met. Above all, this path involves accepting a job and making a commitment to work there, typically for a minimum of 3-5 years. That is why the age of the newhire is so important. The younger you enter the field of trading, the better. A new trader must possess a dynamic personality, entrepreneurial spirit, intelligence, ambition and discipline to succeed in the field. The requirements for academic credentials are surely tougher in French as opposed to English-speaking investment firms where job candidates are judged more on job performance (e.g. the case of Nicolas Leeson at Barings). In fact, the new graduates and assistant traders have priority over the front- and back-office staff in the scramble for front office positions. However, managers in the middle and back offices, as well as in risk are paid very well. These are not exactly the sexiest jobs, but they are well compensated to make up for the lack of glamour.
Job candidates can take the direct approach and submit their applications via the career opportunities page of corporate web sites where they may also find expensively developed training programmes for young graduates to become traders, sales people, structuring people and analysts - in short, the firm's future managers.
In any case, landing an internship at the age of 22 is the key to the future, even though the hardest part is yet to come. Individuals lacking particular qualifications sometimes land jobs in the trading rooms of the world's largest investment firms, given that the recruitment criteria of Human Resources are not always consistent with demand on the floor.
Regardless of the path taken, the trader, more than anyone else in the room, must be able to deal with technical and financial issues. Apart from the university math credentials, the job candidate must also have completed a solid year or two of graduate level finance or at least show a good understanding of economics and finance (Hull's text on derivatives, newspapers, a thorough understanding of financial issues, understanding of the main derivatives and the principles for pricing them, an understanding of the fundamental issues in finance and of the operations of the monetary system and the main players in the capitalist system, awareness of the multinational business news, etc.).
When the time comes to make a change, the trader will find it hard to make the transition to a new career outside the trading room, given the job's degree of specialisation. The high level of compensation in part reflects this reality, as many traders retire after 10 or 20 years of service. A few highly-driven individuals, who have made a name for themselves, launch their own investment funds. One of the requirements for launching a fund is to bring a minimum of several tens of millions of euros in equity.
A day in the life of the trader
Observing a trader at work, the average person may wonder if the job really warrants all those diplomas and other credentials. After all, it looks simple enough. The daily activity of a plain vanilla trader, the most common trading job, is driven by three factors: information, intuition and technical know-how. The first takes up most of the space on his eight or nine screens. Networks, such as Reuters or Bloomberg, deliver world news continuously. Apart from the journalist himself, the trader is the second person in the world to get wind of breaking news. This is pretty close to raw news, flashed onto the screen with little editing: a stream of new press dispatches appearing an average of every three minutes. The trader is not interested in 99.9% of what is displayed. His job is to observe the news stream carefully, focusing only on stories of interest to him. He will also observe a flow of scheduled company releases and economic statistics, among other news. There are also audio announcements, often unrelated to the text on the screen, from the trader's dealerboard, the system which connects him to brokers. Reading information takes up 45% of his work day.
Another time-consuming task involves watching the market and acting intuitively. This also entails information but, in this regard, the trader must make a subjective interpretation of its meaning. He forms an opinion on the market's direction by observing all the signs making up the price action, including price fluctuations and the liquidity of the orderbook. This is a matter of intuition, and it also takes up 45% of the trader's time.
The remaining 10% is spent on market making, surely the job's least interesting and most repetitive task. To issue quotes for his clients, the trader uses an Excel spreadsheet with the useful "pricer" functions invented by quantitative research, calibrates it to correspond to the market and then pushes the F9 key each time a client asks for a price.
Trends in the trading profession: the outlook
Driven by the rising popularity of exotic financial instruments, one of the trader's two responsibilities is taking precedence over the other. The position of risk engineering, where programmed decision-making and academically-acquired skills play a larger role, is slowly gaining ground on the more intuitive role of speculation. This is a risky field because it is based on profits generated on the market's stochastic fluctuations. The more free-wheeling trader is giving way to the financial engineer, a new type of trader far removed from the schizophrenic leading character in "American Psycho". This new breed of trader occupies a decisive portion of the market and shares his profits with the sales, structuring and research teams. The old-style trader is assertive, highly intuitive, always knows what he wants and is well-informed about current economic and financial issues. The new trader boasts impressive credentials and is hard-working, highly disciplined and technically oriented.
This turnabout has led to three main practical changes in the trading room. The first is that prop traders, who symbolise a certain type of trading, and all their responsibilities for the bank's capital, are becoming increasingly scarce. The second is the mounting role of program trading. This phenomenon is tangible proof of the gradual replacement of stochastic trading by determinist trading. Goldman Sachs is a case in point. The firm recently laid off a team of equity derivatives traders in New York and replaced them with program trading. The latest change affects young recruits. Personnel recruitment is becoming a stringent process, like hiring an executive, which was not always the case. Firms always sought out the most motivated, enthusiastic, smiling and assertive job candidates. Technical knowledge, diplomas and grades have never before played such an important role. According to the eFinancialCareer, five years ago only 24% of banks said they went through an accredited graduate programme to recruit traders. Today the figure is above 75%.
On a philosophical level, traders are expected to assume responsibilities that have more to do with hard work than raw talent. The paradox is that anyone can compete for the job, since it boils down to doing the work. Human resources departments are now more exacting (diplomas, grades, internships, etc.), but the job seekers are scarcer in the decreasing number of areas requiring innate ability. Salaries for newly hired traders have already been stagnating for the last five years, which shows that the trader's job is better understood and that he is being monitored more closely. The new trader increasingly resembles a top executive and less that of the solitary free-wheeler.