How I Trade (part 1): 1 minute Chris Farrell interview

Stock traders know that getting a feel for how market makers and specialist move shares is critical to seeing the ebb and flow of the market.  Chris Farrell is a former market-maker turned at-home trader and has a huge advantage in that he knows exactly how the market makers play the game.  In our interview, he talks about how you can use his knowledge to make better trades.

Tim Bourquin: Chris, can you explain your overall philosophy of trading?

Chris Farrell: I always look the market in terms of, it is not fundamental and it's not necessarily technicals that move the market.  It’s supply and demand imbalances and typically what happens, oftentimes in the media, on a day when the market is up, they often say that there are more buyers than sellers and that's what's driving the market up.  Well, that is not necessarily true.  For stock to trade, there has to be an equal amount of buyers and an equal amount of sellers or the stock cannot simply trade.  So, I view the market basically as a collection of buyers and sellers trying to transact and the market will adjust higher when sellers are able to get a higher price for their stock and it will adjust lower when buyers are able to get a better price for their stock.  So, it is a constant process of negotiation that's going on in every single stock, every second of the day as long as the market is open. 

So, within that framework, what I like to look for are temporary gaps between where the buyers are willing to buy and the sellers are willing to sell.  In other words, a wide gap between where the buyers are trying to buy which is the bid and the sellers are trying to sell which is the ask.  Now, as the markets have become more electronic and as we've moved from a market that traded in fractions to a market that traded in decimals.  A lot of these gaps between the buyers and the sellers have appeared to narrow.  You have to use more tools to view the situation.  Now, luckily, there's technology that is at the disposal of any active trader, which allows you to see the depths of the market and that gives you a more true indication of the supply and demand picture in the stock.  The less liquid the stock, the more likely there are to be large gaps between where buyers and sellers are.

Tim Bourquin:  How do you make most of your trading profits?

Chris Farrell: That is one of the most important questions in trading, obviously.  There's a concept, and this is a relatively simple trading concept but it is one of the most important things that a trader can learn especially trading in the New York Stock Exchange list of stocks.  It is known as “clearing the order book” and what that means is that if you see a large seller in the market, if you are going to buy from that seller, you have to be sure that whatever price that that transacts at, that that clears the order book.  In other words, that price is at a point where that seller's entire order trades.  So, I'll give you an example.  Imagine that the stock closed at let's say $5 and on the open you see, five minutes before the stock is open, you see in your Level II screen that there's a seller of 20,000 shares at $4.50.  So 50 cents lower than where it closed.  When you see that, that is not an indication that the stock is going to open at $4.50 just because that seller is trying to sell at $4.50.  He's putting a limit price on it.  So he'll say and I'll sell for $4.50 but no lower than $4.50.  So if there are, let's say there is a buyer of that equal amount of stock at $4.75.  So we have a seller at $4.50 and a buyer at $4.75 and the stock closed at $5. 

But when you see that, absent any sort of other buy and sell that might be queued up as a market order that no one can see, that stock has a very high probability of opening at $4.75 and that's where that buyer and that seller are going to match and if it is for the same share amounts, if they both have the same amount of shares are willing to be bought and sold, what will happen is that isn't a market clearing price.  The order book will have cleared.  So, once that seller is out of the way, it is likely that that stock had bounced back to where it closed the prior day absent other market conditions.  So it's not a guessing game by any stretch of imagination.  A lot of this is based on just reading where the buyers are and where the sellers are and determining from that where the stock will open and then whether that large buyer or seller gets filled and is then out of the way.  This is exactly how the specialist on the floor had traded for decades. 

They basically set the market clearing price and if there are not enough buyers or sellers available, they'll risk their own capital to help clear that trade and they're going to do it a price level that's favorable to them.  They're not in the business of throwing their money away and this explains some of the exaggerated moves that you see, for example, during panic selling where you see stocks just get crushed on the open and then second they print down there, they'd have a drastic move the other way and a lot of times it's based on the fact that the specialist is a large buyer on the open and then people see that print occur.  It catches everyone by surprise and they can't believe it and then it brings bargain hunters in and then the specialist who bought a large block of the stock and sells at a lower price level, then feeds it out for the rest of the day and makes some nice trading profit for himself. 

If you put buys in that are above where the specialist ends up printing that opening stock, you're going to buy it with him at his price.  It allows you to essentially bet with the house.  The specialist is the house.  He's the odds maker; he's the price setter, so you have to monitor what he is doing at all times.