Saturday, February 19, 2011

Summary of rules for a forthcoming session

I have been asked to run a trading simulation for colleagues as part of a training program. There are 30 participants, so will be introducing Producers and Consumers into the mix, also the Insider who peddles rumours based on News. The teams are split as follows:-

1 Market Marker - this is me
3 Locals
4 Investment Bankers with 4 people in each
2 Hedge Fund Managers with 2 in each
2 Consumers with 2 in each
4 Producers with 1 in each

1 dodgy day trader - colleague
1 Settlement person from the Training team.

1) The purpose of the game is to simulate the functions of four participants in a financial trading market – Market-Makers (M), Locals (L) Investment Bankers (B), Hedge-Fund clients (H), Producers (P) and Consumers (C). For the purpose of this simulation we have 1 Market-maker, 3 Locals who together form the Pit, 4 Investment Banks, 2 Hedge Funds, 4 Producers and 2 Consumers.

2) The game is based on trading in a pit environment that also includes curb or off-pit trading and most importantly settlement. Trading is done face-to-face using paper tickets. These tickets are settled in real time by the Settlement Administrator (S). Once each trade is settled by S, that becomes the prime record and is not open to dispute. Financial penalties will be incurred by those who are unable to execute and settle a trade accurately. For the smooth and quick running of the game, please pay attention to the simple rules of price, size, buy/sell to enable settlement to happen smoothly.

3) The game is zero-sum gain so the primary test for each group is to maximise profitability by executing a trading and hedging strategy. Therefore credit is given to all players for the volume of deals that they execute as well as their PL profile during the game. Those that sit on the sideline will be marked poorly. At this point, each group should choose their team's two letter acronym (e.g. "PH") and write them on their name badges and notify S. This is each team's trading ID and is essential to trading and settlement.

4) All groups are trading contract for differences (CFD) whose final level is based on the sum value of the 14 cards that are chosen from two packs of cards. The first pack of cards is numbered 1 to 40. M shuffles pack 1 and hands out 2 cards to each of B. Only B see their 2 cards and therefore the cards are blind to M, L, H, P and C. The second pack contains 100 cards that have been selected from a standard normal distribution multiplied by 10 – note they can be positive as well as negative but their sum is exactly equal to zero. M shuffles pack 2 and chooses six cards and places them face down in the centre. These cards are blind to everyone and with the 8 cards in pack 1 make up the 14 cards that will define the closing price of the contract.

5) Using a simulation of 100,000 games, the average sum of 8 cards from pack 1 is 164 and standard deviation of 29.5, the average for 6 cards from pack 2 is zero with standard deviation of 25. Together, the sum of 14 cards average is 164 with a standard deviation of 39. For those of a mathematical bent, the distribution is Normal and not LogNormal.

6) The role of M is to simply make a continuous two-way market for L and B to trade with up to a maximum size of £5 a point with a spread of 3. Minimum trade size is £2 a point. Being your host for the next two hours, he has no incentive to make money, only to avoid losing and therefore his function is price discover - find a level where there are as many buyers as sellers. M's main advantage is that he sees the most volume of trades and can manage his position accordingly. M also calls the end of each of the six sessions that usually co-incides with achieving a flat position.

7) M is joined in the pit by L who are locals that trade on their own account, nobody else is allowed in the pit. They do not have the obligation that M has to make a continuous two-way market and can show prices inside M spread in size when they feel fit. Their function is to provide liquidity when M is struggling to flatten out and are expected to make some noise while in the pit. They are required to service their clients who are P and C by executing limit orders. Locals have limited capital and are not allowed to carry excessive losses. If S notices that at the end of a session, a L has lost more than £1000 based on mid price shown by M, S can force the liquidation of L and trade the position out with M at three points outside of the last quoted spread. At this point L has to exit the pit and seek a job with one of the other groups.

8) B have multiple functions and therefore will have the largest teams. Firstly, B uses their proprietary information based on their two cards from pack 2 to trade with M and L and take a directional view. Secondly, B must service each H by showing a sealed two-way price in size of at least £20 a point and no more than a 5 point spread. They do this at least once a trading session for each H. B will be judged by how much they generate volume of trading from H clients. Thirdly, B can service P and C by showing them prices when asked or can be more aggressive and show axes to P and C. There is no obligation to respond to requests or show them competitive prices but again B should find ways to attract as much volume as possible and B should benefit from additional proprietary information.

9) H receive private/sealed prices from each of the B during each trading period and are expected to take sizeable directional views. The private quotes present arbitrage opportunities as well as proprietary information on how the B are positioned which H must try to exploit. The only and key condition is that they H are required to have a flat position at the end of the game. They do not have access to anyone other player than B for liquidity, though M will get involved in the last session to help to close out open positions...and it wont be cheap for H.

10) The game simulates the physical component of financial trading, so P and C are the initiators and end-consumers of the underlying physical that the CFD is based on. P and C start the game by execution large trades with M to represent their natural exposure to the physical. P, being producers benefit from an increase in price and C benefit from a reduction. Therefore P execute a Buy trade with M on the opening spread and C execute a Sell with M. Their strategy is to reduce their position to within £20 a point without losing money. After the initial trade, P and C can only access the Pit by leaving limit orders with L who try to fill the order during a single session. Any unfilled orders expire at the end of each session. P and C can place up to two orders with any L. P and C can also approach any B for a one-way quote and can choose to execute or not, thought B can refuse to show prices if they are deemed time wasters. P and C cannot trade directly with H or M.

11) The game starts with six cards from pack 2 turned down and M opens the first session with a 3-point spread in up to £5 a point. To open the trading, M executes opening positions with each P and C on the spread. This is the only real income that M receives. After that, every B must trade on this open quote - this facilitates price discovery and forces everyone to then have a trading axe. Only one person from each B is allowed to approach the pit at any one time, otherwise it gets crowded. Once each P, C and B has traded with M, the market is now open to L who can join in showing alternative prices and receive orders from P and C. At this point M will make subsequent prices to balance his book. Each B must now show their private and fixed prices to each H who must give them fills quickly where they want to. The session will continue until trading dries up and M calls the end bell. At that point all trading stops, all trade settlement is completed and at that point M will turn over one of the six cards.

12) Session 2 through to six continue as session one with M opening prices and every B trading on the new spread. After M has turned over the last card in pack 2, the game enters the final session where the rule that H have to close out their positions is imposed and that each of P and C have reduced their position to below £20. M also has to finish the game with a flat position. B and L are allowed to retain holdings as they see fit. Once M signals the end of the last session, the eight cards from the B are revealed and M will calculate the closing level for the contract. All outstanding contract then settle on that level.

13) Settlement Rules. B can trade with M or L, however once they have completed a trade, they then go IMMEDIATELY to S and present two tickets - one for Buy and one for Sell with the same deal size and price. When executing amongst M and L, L takes the two tickets IMMEDIATELY to S. When B trade with H, P or C then each B take the two tickets IMMEDIATELY to S. P and C fill in limit order forms and give them directly to L. When L completes the order, a buy and sell ticket is created between L and the P or C take the two tickets IMMEDIATELY to S. All deals that L has executed to fill the order are settled with L as principle.

14) Once S receives two tickets, the trades are recorded in the settlement spreadsheet. If the tickets match then the representation in the spreadsheet is now the prime record and no further disputes are allowed. S also keeps track of latest quotes from M to keep a check on each groups PL. Groups should also not crowd S - they are allowed to check their positions but are not allowed to see others. S sits at the back of the pit behind M.

15) There is a fifteenth card and a dodgy day trader! During each session a rumour about news that will have an impact on the market of either -10, -5, 0 (for silly rumours), +5 and +10. Each group should look out for the dodgy day trader (D) person in the room with early news knowledge and decide to work with D and act on whatever information there is to share. He can execute with anyone outside of the Pit in small size up to £5 a point as a way of sharing the gains that come from the information. Each news item is flashed at the end of each trading session. The sum of the impact of the news items is held in the fifteenth card and will be unveiled by M and added to the original 14 cards. Nobody including D knows the content of the fifteenth card, that will be provided by the Training team.

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