Last Updated on 19 September, 2022 by Samuelsson
What is Pit Trading and what is the Trading floor?
Although stocks and commodities are mostly traded online now, pit trading still goes in the trading pits at Chicago Mercantile Exchange (CME) Group and other U.S. exchanges. But what is pit trading?
Pit trading refers to trading activities that go on the trading floor. The term pit (also known as the trading floor) refers to a physical arena at a stock exchange or commodity exchange where security trading goes on. Brokers in the pit use the open outcry system to communicate with one another as they transact for their clients and themselves.
We will discuss this topic under the following headings:
- What is pit trading?
- Understanding pit trading
- History of the trading pit
- The Pit vs. Electronic Trading
What is pit trading?
Also known as the trading floor, the pit refers to a physical arena at a stock or commodity exchange that is reserved for securities trading. Pit trading, as against electronic trading, refers to the traditional way of trading which happens in the trading floors where brokers communicate their clients’ orders via the open outcry system.
In this system, brokers buy and sell different securities by shouting the orders or using some sign language to communicate the order price and quantity. That is, they match the orders of their customers by shouting and through hand signals. By displaying the orders in the open, everyone in the trading pit can participate and compete for the best price.
For futures exchanges that still use the pit, there’s a pit for each commodity traded. For example, CME has a lumber trading pit, a Eurodollar trading pit, an S&P 500 trading pit, and so on. Brokers and dealers have reps in those pits to trade their clients’ orders and place proprietary trades for their own firms.
While the majority of physical trading floors have been replaced by electronic trading platforms, there are a few that still exist, including at the CME Group and Chicago Board of Trade (CBOT) that deal on commodity futures and options, as well as the New York Stock Exchange (NYSE) that focuses on equities, bonds, and exchange-traded funds.
Understanding pit trading
Historically, both futures and equity trading have been conducted on the trading floor of the corresponding exchanges. In an exchange house, the trading floor was organized into segmented areas, called pits, where traders and floor brokers met face-to-face to buy and sell the securities they are trading.
To be able to trade on the floor of an exchange, you must be a member, or associated with a member, of a specific exchange and must have paid for the right to transact business on the floor. Those who wanted to participate in the security market, but were not a member of the respective commodity exchange, had to call a broker who would then place an order on their behalf.
In pit trading, the majority of activity takes place at the beginning and end of the trading day. The typical activity in the trading pits goes like this: clerks take orders by phone or computer from customers in the pit, and runners transmit orders between clerks and brokers. Brokers and dealers may represent themselves, but they may work for firms and trade for clients or the proprietary accounts of their firms. Since all orders are displayed, everyone has a chance to participate in trading activity, while specialists work their own books in the pit, making a market in securities and keeping a ledger of orders awaiting execution.
Now, let’s take a look at these questions
What is a pit broker?
A pit broker, also known as a floor broker, is an independent member of a security exchange who is authorized to execute trades for themselves and their clients on the exchange floor. Owing to the limited space available on the physical trading floor, pit brokers are relatively rare.
Pit brokers are found on stock exchanges, as well as futures and options exchanges. They generally represent larger clients, such as financial service firms, investment funds, and high-net-worth individuals. However, with the advent of electronic trading, there are no longer many pit brokers on the exchange trading floors.
What is open outcry?
Open outcry is the system of communication adopted by professional traders on the trading floors of a stock exchange or futures exchange. Since the development of the stock exchange in the 17th century in Amsterdam, open outcry was the main method used to communicate among traders, until electronic trading emerged in the late 20th century.
The open outcry system involves shouting and using hand signals to pass information about buy and sell orders, including the order price and volume. It works as an open auction, with bids and offers displayed in the open market, giving all participants a chance to compete for the order with the best price. This allows for efficient price discovery. Also, exchanges value positions marked to these public market prices on a daily basis.
What is the purpose of the trading floor?
The general purpose of a trading floor is to give traders a specific place where they can buy and sell the security concerned (stocks, options, and commodities). Trading floors were the only place brokers and professional traders could trade shares among themselves for their clients and themselves.
Before the electronic era, trading relied heavily on trading floors of the security exchanges, as they were the main location for market transactions. It was home to traders and brokers who did the actual buying, selling, and negotiating. Despite the growing popularity of electronic trading, in-person trading happens each day on various trading floors, with brokers interacting with specialists until a final trading price is decided.
These days, traders in the trading pits serve as the face of Wall Street, as they provide a visual for the evening news. Moreover, there is a bit of showmanship involved in the ringing of the opening and closing bells each day, as well as everything that happens in between, and they all happen in the trading pit.
What does the trading floor look like?
The trading floor is a large room with several circular arenas known as pits. The pits have a flat center and broad steps ascending concentrically to the edge. They are often called “a pit” because when the traders trade, they step down onto a certain area and buy/sell securities.
A fast-paced and chaotic environment, the trading floor is characterized by colorful traders trying to outdo each other by shouting orders. Think of them as visually dynamic marketplaces, with traders who wear different colored jackets and badges that represent their brokerages shouting orders to each other accompanied by specific hand signals.
Why do floor traders wear jackets?
It is the rule of the exchange that anyone on the trading floor must wear a coat and tie. Moreover, a normal suit jacket would be too restrictive and too hot to wear in the high activity and high stress of a trading floor.
Another reason could be that if all the staffers for a particular bank/brokerage all wear the same colored jacket, they can quickly see their colleagues. Wearing the same jacket makes it easier to find the right person when the desk staff needs to relay an order via a runner to the trader on the floor — think of it like how the crew on the flight deck of an aircraft carrier all wear different colors to symbolize what job they have on the flight deck.
Does pit trading still exist?
The majority of physical trading floors have been replaced by electronic trading platforms. But even though most trading now happens online, there are a few exchanges where pit trading still goes on, including at the New York Stock Exchange (NYSE), Chicago Mercantile Exchange (CME), and other U.S. commodity exchanges.
The Pit vs. Electronic Trading
- Pit trading takes more time to execute orders: With pit trading, you have to call a broker to place an order. The broker would then call an order clerk on the floor who would then relay the order to a floor broker. After execution, the floor broker would transmit it back to the clerk to send it back to your broker. It is only then that your broker would give you a fill of your order and confirmation. With these many steps, order execution takes more time than electronic trading. Moreover, floor brokers had to make a living and, at times, it was at the expense of the retail trader when they charge exorbitant prices.
- Electronic trading is easier, faster, and cheaper: Electronic trading offers access to trading platforms, lower commission rates, and a sophisticated high-speed trade routing process. The reduced costs of trading have made it possible for more participants to enter the market, which in turn has a good effect on the liquidity. Any trader can transact with any other market participant by making a few clicks on the computer.
- Electronic trading may be prone to manipulations: Some have questioned whether electronic trading can handle turbulent times. In fact, some believe that electronic trading was the cause of the flash crash since high-frequency trading made possible by electronic trading is responsible for an increasingly larger amount of volume on the stock exchanges.