In today's 'Midweek Commentary' we look back to the days of ‘The Pit’.

The Trading Pit:

When most people think of stock exchanges, they often think of the fast-paced, chaotic environments characterized by colourfully dressed traders trying to outdo each other by shouting orders.

They are bustling and noisy spaces that are filled with traders who wear different coloured jackets and badges that represent their brokerages. Pits are also called trading floors or trading pits.

The majority of activity takes place at the beginning and end of the tradingday. Clerks take orders by phone or computer from customers in the pit, and runners transmit orders between clerks and brokers.

Brokers and dealers may represent themselves. Alternatively, they may work for firms and trade for clients or the proprietary accounts of their firms. Specialists work their own books in the pit, making a market in securities and keeping a ledger of orders awaiting execution. Since all orders are displayed, everyone has a chance to participate in trading activity.

There are very few physical trading floors that actually exist today.

The NYSE and the Chicago Mercantile Exchange (CME) Group are two of the major exchanges that still have pits. That's because the trend has been to move away from the open outcry system and toward electronic trading. Since the late 1980s and early 1990s, many of the world's large exchanges have made the transition.

The ‘Olden Days’
When a young law student called Leo Melamed arrived at 110 North Franklin, Chicago, for a job interview at what he thought was a legal firm in 1952, the chaotic scene he witnessed blew him away. Merrill Lynch, Pierce, Fenner & Beane was actually a brokerage, and the job was for a “runner” who shuttled messages around the trading pit of the Chicago Mercantile Exchange where financial contracts were settled on everything from bonds to eggs.  

The maelstrom of people in coloured jackets shouting and jostling, marking deals on enormous blackboards and recording the end-of-day results with Polaroid cameras hooked the young Melamed.

After finishing law school and quickly aborting a stint as an actual lawyer, he returned to “The Merc”, and rose to be its chair in 1969.  

Ed Davies of The Portfolio Platform tells a similar story of how it changed again during his time trading. ‘When I started University in 1997, the LIFFE floor was still open outcry, when I left, it wasn’t.

The shouting had moved to multiple telephones and microphone systems’.

On Friday 24 November 2000, at 5 pm, the last three of the once 26 open outcry pits were permanently closed. ‘By the time I graduated, it was a completely different game and many of the people I was working with were reluctant to let the old days die. Stories of life in ‘The Pit’ were constant, and to those who were new to the game, it sounded a lot like a school playground where the big kids pushed around the little kids.

Skill and intelligence seemed to only make up a small part of the requirements to be a successful trader in those days. Tall people were more visible and aggressive personalities stepped on the rest.’

‘Fortunately, by the time I got there, everything had already gone ‘upstairs’, meaning it was screen-based and in an office. When I arrived at work for my first day in the city, I saw rows of desks with screens piled high and tradersbuying and selling at the click of a mouse’.

The trading pits where Melamed and many other titans of finance learned their trade — and immortalised in popular culture by the movie Trading Places — had been slowly dying out even before the pandemic.

What is ‘Open Outcry’?
This is the method of communication between professionals on a stock exchange or futures exchange, typically on a trading floor. It is shouting and the use of hand signals to transfer information primarily about buy and sell orders.

In an open outcry auction, bids and offers must be made out in the open market, giving all participants a chance to compete for the order with the best price. New bids or offers would be made if better than previous pricing for efficient price discovery. Exchanges also value positions marked to these public market prices on a daily basis. In contrast, over-the-counter markets are where bids and offers are negotiated privately between principals.

Since the development of the stock exchange in the 17th century in Amsterdam, open outcry was the main method used to communicate among traders. This started changing in the latter half of the 20th century, first through the use of telephone trading, and then starting in the 1980s with electronic trading systems.

As of 2021, a few exchanges still had floor trading using open outcry. The supporters of electronic trading claim it is faster, cheaper, more efficient for users, and less prone to manipulation by market makers and broker/dealers.

However, many traders still advocate for the open outcry system on the basis that the physical contact allows traders to speculate as to a buyer/seller's motives or intentions and adjust their positions accordingly.

As of 2010, most stocks and futures contracts were no longer traded using open outcry due to the lower cost of the aforementioned technological advances. As of 2017, open outcry in the United States was very limited, such as in a much more stream-lined form at the Chicago Board of Trade owned by the CME Group.

Orders are matched in the pit, allowing everyone to participate and compete for the best price. Brokers and dealers trade their clients' orders and place proprietary trades for their own firms.

The majority of physical trading floors have been replaced by electronic tradingplatforms but there are a few that still exist, including at the New York Stock Exchange (NYSE).

Signals
Traders may shout, wave their arms, and use special signals with their hands to communicate their trading intentions on the floor.

Hand signals facilitate quick trading and make it possible to be heard above the crowd. For instance, when a trader puts their palms toward their head, it indicates a buy order. If they want to indicate a sell order, they face their palms away from their head.

Some exchanges use different signals, though. For instance, a trader on the floor of the Chicago Board of Trade (CBOT) indicates the month of January by using their fist to mimic jamming something into their head. But someone working for the CME Group holds their throat between their thumb and index finger to denote the same month.

Although open outcry is no longer very common, trading pits at exchanges now look like a hybrid of the past and the present.

There are more screens, and less jumping and shouting, but they still resemble the old ways in essence.

There is still some appeal to the open outcry system but electronic trading is much cheaper to run. Cutting out the middleman means a drop in fees and commissions for traders and subsequently investors. There is also a higher degree of productivity due to the speed with which orders can be organised and placed.

The majority of stock exchanges do now operate through electronic tradingplatforms, which were first introduced in the 1980s. Exchanges like the NYSE and the CME Group kept their trading floor but began cutting brokers from the floor in 1984 after adopting an updated system that operated by phone.

The 1990s saw more automated systems rush in with the rise of internet technology. This period saw more powerful computers, higher trading volumes, and a drop in trading commissions. The 2000s saw the rise of algorithmic trading and faster technology.

With this boost in technology, traders and firms are able to benefit from a higher volume of trades during the trading day.

Today
Trading has now overwhelmingly shifted into the world of algorithms; even the New York Stock Exchange is largely a TV studio, with most of the actual tradingtaking place at its data centre in New Jersey.

Others have survived, including the NYSE’s Arca options floor in San Francisco and the Box Options Exchange in Chicago. Bucking the trend, CBOE Global Markets, where the Vix volatility index is traded, is building a new and bigger trading floor to accommodate hundreds of traders and will move there in 2022.

Technology advances, and we must advance with it. Holding onto trading pits is an example of some investment firms having too much power and not wanting to let the past go because they’re too afraid to give up what they have.

If they make a fortune by ‘bullying’ the pit, then what happens when that pitcloses?

Computerised order books for futures and stocks have completely changed the market place. Algorithm designers are able to programme computers to look for patterns and place trades without emotion.

One day, there may be no need for traders at all, perhaps it will all be done by AI’s trading our accounts for us while we carry on with our day jobs.

For those of us whose day job is trading, this is a worrying thought, although we are many many years of reaching that reality.

However, what we can now do is link retail accounts to our professional traders with years of experience, and allow them to place the trades on the exchanges for you, as we have always done for ourselves.

The Portfolio Platform is a fintech platform that has the technology to do just that. Any retail investor can set up an account at their brokerage, subscribe to the traders on TPP, and their portfolio will autotrade itself.

If it sounds a lot like the future is already here, then that’s because it is. You can now set up the equivalent of your own hedge fund from the comfort of your own home and let the traders do their thing.

Traders have one job, to make money. And now they can do that for you.

Please do get in touch if you would like to know more about opening your own portfolio on The Portfolio Platform.

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