IB Management Chat Transcript - April 1, 2004

The following is the transcript of IB Management Chat with guest speaker Mr. David Graff, of Stat Capital, a market maker in CBOT mini-sized Dow futures as well as the new mini-sized Dow options and TMI futures. The topic is Trading and Making Markets in CBOT mini-sized Dow Futures & Options.

Please note: Security Futures are highly leveraged investments and are not suitable for all investors. You must carefully review the Standardized Risk Disclosure for Security Futures before trading these products.

David Graff, of Stat Capital: I thought I'd start today with a brief history of my trading experience. My first floor trading experience was in soybean options and let me tell you it was baptism by fire. I started trading in the fall of 1987 and there was a drought that following spring. I really was just learning to trade and I had to learn and incredible amount in a very short time. October of that year was the stock market crash. The firm I was working with was also managing a large index option fund and had to call me back to help them. Although I have seen many volatile scenarios afterwards, that first year prepared me for the rest of my trading career.

Since then I have traded options and futures on every trading floor in Chicago. In 1993, I started my migration to electronic trading. I went to work for a hedge fund that primarily traded index arbitrage. We traded baskets of stocks against options and futures contracts. This was my introduction to electronic trading. The stock hedge was executed through an electronic system that sent the orders to the floor of the NYSE. The execution systems I use now are much faster and more advanced. For the next five years I split time between the floor and off floor trading. During that time the hedge fund I was with became an investment advisor for a bank and we used our knowledge of index products to create and manage a large cap and small cap index funds for them. The original investments in the funds were about $20 million dollars and eventually grew to nearly $500 million. By 1998 I completed my transition to off floor trading. I then concentrated on index arbitrage, risk management for the groups option traders and management of the banks index funds.

In early 2000 I joined a new firm where I met one of my current partners, Jim Gosselin. I was given the opportunity to start an index arbitrage desk. We traded baskets of stocks and ETFs (exchange traded funds) against index futures. I was responsible for 9 traders and their staff. We traded between 1,000,000 and 2,000,000 combined shares of QQQ, SPY and DIA every day. That firm ended up being sold so Jim and I partnered up with a few other traders and started STAT. We began by making markets on ETFs and equity options and then worked our way into futures and warrants. We were approached by the Chicago Board of Trade to see if we could help them with their new electronically traded Dow Mini-sized Dow contract. At the time the contract was trading about 8,000 contracts a day and had a comparatively wide bid ask spread to other similar products. With a combination of third party software and our own programming we began making markets based on a complex set of trading rules that brought together our experience as floor traders and our expertise in electronic markets. Within weeks we were able to bring the bid ask spread down to a respectable width and now it is the narrowest among index futures. The average daily volume in the Dow Mini-sized Dow is now around 60,000 to 70,000 and growing. We have been successful using similar trading technique in other products.

February of this year the CBOT started trading Dow Mini-sized Dow Options and TMI futures. We were given the opportunity to make markets in these products as well and have been since the first day of trading. I feel the Dow Mini-sized Dow Options have an extraordinary chance of becoming a premiere index option contract. For those of us who like to trade electronically it has the tightest spreads and the fastest execution because it is a pure electronic contract. The orders don't have to go to the floor of an exchange. The TMI futures are exciting because they cover US small, mid and large cap markets in a single futures contract. TMI futures are currently the largest electronically traded US stock index futures with a contract value of approx. $135,000. Tick size is $25.

At STAT one of our strategies is to look for relationships between different products and try to identify the leader in a group and how its price movement can help us predict movement in others in the group. Once we accomplish this and back test it we start to trade it by hand so we can get a better understanding of the nuances in that particular trade. We have a trader and a programmer trade together for a while and then we start the process of automation. We define our risk parameters and write the rules that we feel give us an opportunity to be profitable. Many of our trading algorithms are modifications of algorithms already in production. As market conditions change and as new products become mature we usually have to revisit our rules and modify them. The trading arena is extremely dynamic and traders need to adapt to the market. The ways we make money trading today are not always going to work, so as I'm watching our trading platform with one eye, I am looking for opportunities in other markets with the other.

When the CBOT asked us to participate in their market-making program we thought that we could use some of these techniques to help us make markets. Our first thought was OK, we have a not so liquid contract, what can we do to change that. Our philosophy was to take liquidity from other areas and transfer it to the product we would make markets in.

Once we added enough liquidity the traders would come and the product itself would generate its own liquidity and continue to grow. The mini-sized Dow is the perfect example. Last month was the first time it traded over 100,000 contracts and we were very proud that we had a big part in the contract getting there. Since we started making markets we have been between 5 and 15 percent of the volume every day. Another strategy we use is more of a technical type trade. One that looks at the trading vehicles own dynamics and like a chartist decides when it has crossed into a buy or sell range. Unlike the leader of the group strategy this one has relatively large profit and loss swings. In our back testing we saw that if we were patient it would be profitable for us. The hard part was learning to be patient because our other successful trades were very high frequency. In the mini-sized Dow we may be in and out of 5 to 10 trades in a less than minute.

At STAT we are involved in many other strategies and trading arenas that I haven't mentioned, so at this point feel free to ask any questions about the markets, trading or technology.

Nick: What is a TMI future??
David Graff: TMI is a Dow index that is cap weighted and is composed of large, mid and small cap stocks. There are about 1640 stocks in the index.

eleen: How does trading dow options compare to oex options?
David Graff: They are very similar in volatility and skew. However, the dow mini-options are completely electronic making it possible to trade them in very tight spreads.

wendell: What trading software you use for trading?
David Graff: We started with using third-party software but eventually build our own completely proprietary trading platform.

will4: What are the mechanics of making an electronic market? How is it different than making a market on the floor?
David Graff:Electronic markets have the benefit of having complete anonymity. Speed is another consideration. The computer reacts much more quickly either for or against you.

mhals: The e-mini Dow can be a little twitchy or jerky -- is that due to the liquidity issue?
David Graff: Since the min-dow trades in 1 point increments ($5) it may look jerky but on a relative basis may not.

MrPow: I am a new trader, can I ask some simple question?
David Graff: Fire away.

eleen: What is the dollar value of each mini dow option and how does the spread compare to oex spreads of 0.3-0.5 pt?
David Graff: It is $500 per point

eleen: What is the dollar value of each mini dow option and how does the spread compare to oex spreads of 0.3-0.5 pt?
David Graff: It is about the same width as the OEX.

MrPow: Do you think general technical analysis, e.g. resistance break out will make money in trading mini dow future?
David Graff: It work as well but only in a very trending market and the parameters need to be adjusted to the volatility of the market.

ric: Do you see much manipulation of the mini Dow to say run stops ie the eminis (especially around the noon hour)?
David Graff:>No. Because the basket of stocks is so easy to execute, it is very difficult to manipulate the Dow futures.

TMI_Underpricer: Why does the TMI trade belowfair value?
David Graff: One of the reasons may be the ability to short the underlying basket of stocks.

TMI_Underpricer: Why does the TMI trade belowfair value?
David Graff: It is hard to short some of the stocks in the basket and they may have a reduced short stock rebate.

ACMe: What options are available to hedge the mini dow?
David Graff: You can hedge it with the underlying basket or an optimized basket or ETFs or other correlated index products.

peteg: I have simple questions, too. Why a trade a future rather than an option?
David Graff: Much more liquid and no theta concerns.

ymt: Is there a leading or lagging relationship between dow futures and dow index?
David Graff:During very volatile times the future will always lead the cash. When it is extremely slow the cash may creep and the futures follow. But safe to assume that futures will lead.

harry: Where do we get the description of the mini's?
David Graff: CBOT website at www.cbot.com. On their website you can even register to receive live quotes.

jenyce: You say you are in 5 to 10 trades in less than a minute in the mini dow. What is your scalping target?
David Graff: We don't have scalping targets. We generate a theoretical value and make markets based purely on that value If we our pricing is accurate and we should naturally be able to scalp.

joe2: How many contracts could you reasonably execute at one time?
David Graff: Depending on how much market-impact is acceptable you could trade anywhere from 50 - 200 contracts.

Ants: Why do the MM's pull their size just before an important report, allowing the market to spike? David Graff: Electronic market-making is based on fair-pricing models conceived in an orderly market. This tends to breakdown during important news events.

MrPow: Which part of profit is larger? The bid-ask spread or the trading profit?
David Graff: In the Dow because the bid-ask spread is so tight most of our profits are generated from trading.

iftrader: Do you think the CME will ever lower NQ/ES tick size? (to compete better with YM).
David Graff: Not if their members have anything to say about it !

kexi: Would you please compare Emini sp and emini dow.
David Graff: They are highly correlated and notionally close. However, the dow has a much tighter spread compared to the mini-spu. Also it is much easier to watch the stocks in the underlying basket to ascertain their effect on the future.

will4: What elements are in your pricing model? David Graff: The pricing model is based on the relative pricing with appropriate filtering.

mhals: The after hours market on Globex looks so thin as to be too risky. Do you agree?
David Graff: It is riskier because of less liquidity but as the same time the market moves are smaller.

ymt: Is YM the most liquid and tight spread among dow futures or is there a better one? YM is the tightest

MrPow: Why future will lead? I am interested
David Graff: Because it is easier to trade a single security rather than trading a basket.

joe2: So you provide trading around that value, and when do you change that value.
David Graff: It is relative pricing so when the market conditions change or one of the components in the pricing model changes the price automatically changes.

OneLot: Do you think there is a relationship between your profitability and market volatility?
David Graff: Because we built our pricing model to be very efficient and fast in changing market conditions where mis-pricing opportunities are the greatest we do relatively better than slower ones.

Pierre: Would you watch all stocks in the index or a subset?
David Graff: With the Dow it is not difficult to follow all the stocks but with a larger index we would prefer to look at an optimized subset.

iftrader: "Not if their members have anything to say about it ! " Why is lower tick size good for you but not them?
David Graff: The lower ticksize is good for the individual investor.

Nick: Do you think the Russell (AB) is better to trade than the ES or NQ's??
David Graff: Depending on what your objectives are and what your strategy is. The Russell tends to be trendier than other indices.

David Graff: Thanks for the great questions We are going to call it a day here. If anyone any questions on the CBOT Dow complex send an e-mail to dowinformation@cbot.com.