Having explained how to place orders, I now need to explain why we place orders.
What makes us decide to go long or short at any given time?
I call this topic understanding value. The job of a market maker is to understand the
value of his contract right now and then work out can he buy cheaper or sell higher
using the spread, right now. The reality is that we can’t or won’t trade on most
spreads because we won’t always know the value but there are still hundreds, perhaps
thousands (if we were fast enough) that do offer us opportunity.
I have already explained one input into value, namely queue position. For slower,
thicker markets if there are already too many on the bid or offer we can’t trade there.
From a value/edge perspective they offer us nothing; in fact they take value and edge
away. So for these markets, the first thing we do is to scan the bids and offers to see if
we can trade at the current price. If the answer is ‘no’ , we have to wait until this
situation changes. Orders get pulled and traded against so this is a constantly
The next input into value is the need for and use of correlations.
There is a big difference between price and value. You cannot determine the value of
something just by looking at its price. You still can’t judge the value of something by
analysing its volume.
Here’s an example. I tell you there is a small Ford family car that they sell for
$20,000. You know the price. I now tell you that they sell 1,000 of these cars each
month. Now you know the volume. But if I asked you now, ‘is this car good value?’
You cannot provide an answer with the information provided.
Value is a relative concept. If I now told you some additional information; namely
that Toyota sell a very similar car and it also sells for $20,000. Now you can judge
whether the Ford is good value; you would probably (hopefully) judge that it is fairfrom a valuation perspective. In fact we all probably use this type of analysis
whenever we buy big items such as cars, computers etc. But when people trade they
usually forget this.
In trading to make these judgments of value we need to use correlations. We must
research our market and find which markets correlate well with it. As I explain in An
End to the Bull, both positive and inverse correlations are best if it is possible to get
Remember though, that correlations are just one input and we shouldn’t trade each
uptick or down-tick in a correlation (correlations are rarely near to 100%). However,
we use them as a guide to which side of the spread we would want to trade from.
They are one of a few inputs into value, don’t become just a correlation trader (their
success rate is too unreliable alone)
Value can change even if the price doesn’t; this is important to understand for our
trading. If we go back to the car example. If Toyota cut the price of their car to
$18,000 and the Ford car remains the same, if I now asked you if the Ford is good
value the answer has changed. The Ford is now expensive. But its price hasn’t
changed. However, if we look at how markets work, we would expect fewer people
to buy these expensive Fords now and so eventually Ford will have to drop its price.
This is the mechanics of a market.
There is one huge point to make here and it goes to the heart of a market maker’s
edge. By watching these prices, trade by trade and using this concept of value, we
would know as soon as Toyota drops its price, that the Ford is now expensive.
However, technical traders won’t see this; it isn’t on the graph. Only when, over time,
the volume drops off and then Ford cut the price will they see that $20,000 is
expensive. So, they will always see this type of information later than us. It is the
same for technical traders in our markets. Watching trade by trade data and using
correlations to help judge value, will help us to get ahead of the technical traders.
Two big points here; first, most retail futures traders use technical tools; second and
following on from that, we don’t need to have edge over everybody in a market, we
only need to have edge over enough people. As long as most retail traders continue to
look at markets in the way they do, we should continue to have this edge. With the
prevalence of technical analysis in the ‘education’ business, I don’t expect things to
Back to using this to trade. Essentially what we want to know is that our contract is
trading here at point X with other markets trading at points Y and Z. If the othermarkets say, drop sharply we may expect ours to as well. By doing this, we
understand the context of the current price action. We don’t simply say that our
contract is good value at 15. Instead, we say that 15s are value with other, correlated
markets at X and Y. If the context changes we don’t simply expect 15s to be a ‘level’.
This is a huge area of difference between us and those who use levels. Anyone who
uses support and resistance levels and any other form of information that does not
include context, will be making very simplistic decisions. Understanding context
helps us to make more robust decisions and is one way that value traders are
differentiated from price traders.
Another point on using correlations. We must watch them tick by tick, trade by trade.
Each new uptick is a potential new reference for value. So, for example, I use the
change on the day figure to watch correlations (some people use DOMs for them). If
a contract is +16 on the day and then prints +15, this is a downtick and a potential
signal for value to move lower. Here, the market is still up on the day but it is now
ticking lower. Remember, we must trade the ‘now’ – what is happening right now.
Here, right now, our correlation is ticking lower so that is the important information.
I should additionally add that we only use correlations when it is clear they are
correlating well with our market. Some days these correlations are strong and some
days they are weaker. We must be able to judge day by day and intra-day how strong
these are and if they are weak we will not be able to use them. Hence on those days
our decision making is more difficult and we may even decide not to trade. Strong
correlations are an excellent tool for traders.
The final part of the jigsaw as far as value is concerned relates to what is the standard
economic definition of value; namely the value of a product is the price that people
are willing to pay for it. For our trading this means watching the market trade by
trade and determining where the heaviest volume is (for slower markets). If for
example, the market is trading like this:
15x 5 lots, 16x 50 lots, 15 x 2 lots, 16x 30 lots etc
we would determine that 16 was value in this context.
Market makers are essentially trying to buy cheaper than others are buying and/or sell
more expensive. Before we buy 15s we want to know that there are others who are
paying 16 (same but other way around for short trades). We do not want to buy 15s if
we have not seen anyone else buying 16s. Otherwise who will we be selling to or
buying from? By doing this, we are not buying or selling on hope; we know when we
buy there are others (of decent size) who are paying more and similarly when weshort we know there are decent size traders who are selling lower. Note that for this
purpose, we do not care what the 1 lot traders are doing; they do not tell us value.
Remember you have to add this to the use of the spread to see how we get filled. So
an example of our thinking would be like this.
If the market is 15b/16o with bigger trades at 16 and correlations suggesting a move
higher and the size of the bids and offers suggest we can enter and exit quickly, then
we would look to place a 15bid looking to buy there as part of the two way business.
Remember too that we want/expect a quick fill. So if we haven’t been filled when we
had expected, we must pull the order.
Note the number of pieces of information that we require in order to place an order.
We are aiming for high percentage win rates so we seek out trades where a number of
factors are in our favour. The spread already builds in it some edge but now we are
buying 15s when we know that others are paying 16 and we are doing so with
correlations supporting that decision to buy and with liquidity suggesting we can get
in and out quickly. If you add all this up together, it equates to a lot of edge and
positive information for our trade.
I should add here, that for the purpose of this manual which is aimed at new market
making scalpers, I am explaining one style of trading, namely only following the
current direction from all markets. Experienced scalpers can also look to fade certain
moves however, fading is always a more complex technique and to start with I don’t
want traders to try it.
If you have conflicting evidence, some points are pointing to buying but others are
not so supportive, then we shouldn’t trade. If you choose to trade with only some
supporting evidence, it would be what I term an ‘aggressive’ trade. If the trade fails
you can leave that trade alone for the rest of the day. However, sometimes traders
back their instinct and I’m not totally against this as long as you respond accordingly
if the trade fails.
So far, we have looked at slower markets but how do we judge the current value for
faster markets which are jumping around? Obviously we can’t use the same method
of trying to work out where the heavier volume is because of the jumping. So the
method we use is quite simple (it has to be due to the speed we are trading at). Simply
we use the last trading price. So if a market trades 15 then jumps to 18, 18 is our new
reference point for value. Note we still use correlations too for that part of the value
equation. Also remember that in faster/more volatile markets we will be placing
orders further away from the last value print.It should be noted that this form of value analysis is more simplified than the other
method and so will not be as reliable. So be wary of trading each uptick/downtick
with these faster markets. I’ll talk about this more in the chapter on trading the chop
versus trading moves. It is very easy to overtrade fast markets believing that each
new trade is a new value. We still want to make sure the correlation is supporting our
trade and if there is conflicting evidence or no evidence from the correlation, we
As with everything in this course, do NOT use this value analysis with any form of
technical analysis or volume analysis or indicator. Ideas such as support and
resistance levels, accumulation, absorption etc are NOT ideas to be used by market
making futures scalpers
Having explained how to place orders, I now need to explain why we place orders.