Traders and Trading – what’s it all about?

Published on August 28, 2020

“One day I’m feeling down on the ground, the next I’m up in the air”

Sandie Shaw could have been singing about traders in her 1969 Eurovision Song Contest winner, “Puppet on a String”. The psyche of the trader is binary. They rarely find themselves in the equilibrium that other less mentally stressful jobs allow. Trading is an emotional rollercoaster.

Energex have recently completed a pair of assignments on the establishment of trading entities in the oil space (oil’s reported death not withstanding) and this, together with reflections on a recent piece by this writer on “The Good Old Days of Trading”, has awakened a wider client interest in trying to define what trading is, what makes for a good trader and what are the success factors behind a good trading entity? Based on personal experience in setting up and running trading businesses, we at Energex, are at the forefront of working with clients to help them understand these issues as they create trading competencies.

Myths and misunderstandings pervade what, for many, is an occupation perceived to be gambling carried out by thrill seekers riding high on the largesse of hoodwinked employers while scalping their colleagues!

For others, trading is believed to be an annuity, a stream of earnings that just keep coming – although who knows how! Think of Enron in this context perhaps, yet there are others positioned firmly on the right side of the law who also seem to take trading returns for granted. Most recently, at the BP strategy re-launch, we heard that “the company’s huge trading business…can push returns well into the double digit range”. While BP may have been , along with Shell and Total , one of the most sophisticated and consistently successful “trading ” majors over the years, to promulgate such returns forward across non fossil and fossil fuel light markets (gas), smacks of the annuity trap.

It is worth noting at the outset that, despite the language of “punting” and the “bet”, trading is not gambling. There is a definitive difference, which is well set out in Bethany McLean and Peter Elkind’s  book, “The Smartest Guys in the Room”. A gamble is a risk created especially for profit whereas trading speculates in risks inherent in a business at the market interface. And risk takers can also be distinguished from hedgers, who are risk managers. Then there are the risk averse who sit ever on the fence.

There are flat price traders, volatility traders, relative value traders, physical arbitrageurs and day traders all doing different things across the wide canvas that is “trading”.

Perhaps it is easier to define what a” trader” is, not by purpose, but rather by where the undertaking occurs- i.e. at the market interface. In this way a trader can be a risk taker, a risk manager, an arbitrageur or, may even sit on the fence (“if in doubt, stay out” being a useful mantra).

There are other competencies that have developed  over time in a Smithian division of labour as markets have grown and matured. Originators, Structurers,  Quants, Sales Traders (especially in Equities markets), Marketers etc.  They are all part of the commercial deal making process – they may find, construct and price, but the successful  monetisation of their efforts falls on the skill of the trader to realise the profit through his or her authorised level of activity at the market interface.

At the inception of tradeable energy markets, the trader would do all these things – lunch the client, sell the deal, price it up and execute. The advent of “fast ” markets put paid to such a comfortable work life however.

For many of the early successful traders, privileged information in what was an opaque business, or the ability to do difficult things in difficult places were the competitive advantages. However, insiders and the buccaneers are now (almost) no more. The successful trader needs to embody some very different aptitudes and even then the right behavioural traits are only necessary but not sufficient. There needs to be both organisational support and the critical element of competitive advantage in addition.

Successful individuals who succeed consistently in markets over time (as opposed to the those who benefit from the occasional upside of chance or play the free personal optionality game) need to be non-egotistical (to concede that the market is smarter than they are), to be calm under the pressure of fast markets, to be decisive (“on the one hand but on the other” won’t cut it), to be disciplined and to be arithmetically agile (the complex maths can be left to the quants who deal beyond the boundary of human rationality) and have an enduring drive to make money. One must not forget the importance of experience, especially the experience of the pain of loss. Superior judgment is borne of such experience even if there is a growing tendency to abrogate human judgment in favour of the machine.

Having found the right individual (an heroic assumption in the macho – who shouts loudest – trading game), the organisation must also do its bit to round off the traders ability to succeed and to cradle success for the entity. Again, this is not at all straightforward in practice. In theory, both trading and firm management must understand and buy into the competence of trading within their organisation and it must be an activity that is clearly aligned to the strategic objectives being pursued. A seriousness of purpose begets a seriousness of execution. It is insufficient to follow the oft quoted upstream oil company route of labelling the traders as “ the ones who get rid of the stuff”.

A focussed management team must then be confident enough in its systems, controls and people to be willing to delegate as much authority and decision- making ability to the lowest transaction job grade possible. Trader performance needs to be regularly monitored for discipline, risk adjusted profitability and quality of decision making (noting though , that good decisions can generate losses but still be acceptable). Yet monitoring must stop short of micro-management and deal evaluation over an inadequate period of evidence. The trader will need to be trained, supported by other contiguous specialists and encouraged while accepting that the delegation of authority comes with the assumption of responsibility and accountability.

Traders and trading organisations fail frequently, sometimes catastrophically (often because the reward structure begets bad behaviour). The history of oil markets is littered with failure, false starts, exits and restarts in an attempt to perfect the alchemy.

If the person is right, the organisational input clear and clean, then the final element to move from necessary to sufficient is the competitive advantage- the “edge”. An enlightening paper authored in the early 1990’s by Alberic Braas and Charles N Bralver is as relevant now as it was then. In “An Analysis of Trading Profits: How Most Trading Rooms Really Make Money”, the authors decry speculative position taking (in the sense of outguessing the market) as a reliable and consistent source of profit, while exhorting the value of the “turn” (bid /offer spread, short term arbitrage, day trading – now mostly replaced by pattern recognition and price path “algo” trading) but most importantly, they cite “customer business” or flow, as the only reliable source of revenue. In this analysis, the information and market positioning consequent on ” being in the flow”, is the competitive advantage being promulgated.

Of course, this is not the only source of competitive advantage and in recent years, the mining of optionality inherent in a diversified portfolio of assets and near assets has been the most successful revenue generator albeit still somewhat cyclicality dependent.

Superior data and artificial intelligence applications may also be a temporary competitive advantage but the very nature of big data and its widespread availability for a fee means that this ultimately becomes a “leveller” as opposed to a competitive advantage. But perhaps the focussed presence in a specific niche area where superior experience counts, such as in gasoline blending, can still offer competitive advantage.

Possibly then, a well run business with clear objectives, staffed by the right folks and mining their competitive advantage could conceivably be considered to be an annuity business in theory.

In practice, experience counts and this is where good judgment comes from – judgment to focus on the right place, with the right people and the right organisational wrap. A sort of “following the (social) science”!  Can, as in BP’s new strategy launch, these qualities (acquired in the old fossil fuel trading world) be transplanted into new endeavours and less liquid markets for the same outsized returns?  This is likely to be a contested assertion. Only time will tell if optimism is being confused with probability.

Trading is hard to define, hard to succeed in and bad for the blood pressure and yet it holds an allure and a mystique that even machines will not nullify. Most of all, like the racehorses, the dream of success and riches is somewhere , just at hand… hopefully!