What “Everyone” Thinks

I’ve been spending the past 3 days on the “LSE City Fast Track” program, where they took selected members from the Finance department on a little schpiel to various accounting firms, banks, and financial regulatory institutions in London. It’s been an amazingly eye-opening experience, though I suspect that I had a different sort of experience from my fellow wide-eyed, eager-to-please coursemates, but more on that in a later post.

I’d like to blog about the common perception of trading, or I suppose what “everyone” thinks that they know about trading. Every time I hear the common misperceptions about trading, I have an irresistible urge to correct them, make a strong opinion, etc, but whatever I say usually falls on deaf ears. Which is very comforting, because that means very few people can bring themselves to do what I’m doing, which means that I can keep doing what I’m doing for a very long time.

My coursemates are very bright people who have all gained entry into one of the most academically challenging programs in the world at the Masters level. Most, however, have no clue about what they want to do in life. (I mean, who really does?) I don’t claim to have more financial knowledge than my fellow classmates – on the contrary, I have absolutely no interest (and no knowledge) about the whole schbang about valuations, EBITDA, strategic alignment, and all that nonsense.

However, I do know just a little bit more about speculative trading than other areas of finance, and I can immediately point out the faults in my coursemates’ views on trading:
1. You need to be constantly plugged into the news in order to be a successful trader.
2. A traders’ skills are less transferable than other areas of finance, eg in investment banking.

I’ll address the first one here, and the second one tomorrow or in the next few days. (Believe me, I have LOTS to say)

Myth 1: Being constantly aware of the news is necessary if a trader wants to be successful.
First of all, there are 2 types of traders: fundamental and quantitative. Most traders would fall in one category or the other, or have a combination of both. Fundamental traders care more about economic data, because they use economic “fundamentals” to make decisions, and probably rely more on financial news.

Quantitative traders are very different. They rely purely on price, volume, or some derivation of those figures in order to make decisions. Quantitative traders have clear, distinct rules on when to get in and out of the market based purely on price and volume.

When you mention “trader”, most people would think of a fundamental trader, and it’s easy to see why. During the Fast Track program I had an opportunity to tour a trading floor with rows and rows of traders sitting in front of 6 screens each. 1 of those screens was usually plugged into Bloomberg to get the latest economic data. It’s a common belief that once news comes out, you have to act on it in seconds if you ever want to make a profit.

Let me point out why this is wrong, very wrong. While it’s true that news like the unemployment report, housing figures, retail sales, etc do affect asset prices when they are released, this effect is often temporary. Say the market is going up, and a bad news report comes in. How many times have we seen prices dive for that day, only to climb right back up again the next day? Did the unemployment figures suddenly change the day after the news was released? Of course not. The fact is that the bad news was probably already priced into the market BEFORE the news came out. If the market was moving up before the news came out, that meant that the “smart money” (ie the insiders, the big players, the people who can move the market) felt that the market should go up.

The temporary plunge in the market was due to the actions of the common traders, those reactive traders who don’t know what’s going on. They see a bad news report and they panic, selling as fast as they can. What they don’t realize is that the “smart money” is still pushing the market up, which is why prices suddenly recover the next day.

Price, therefore, is the one true indicator about where the market is going. Financial news, analyst reports, economists’ forecasts, etc are all distractions, their effect on the markets is random and miniscule when you compare that effect to the overall market. Quantitative traders take advantage of this fact in order to make trading decisions.

However, whenever I mention quantitative trading, I often get a “oh please, not that technical analysis crap again” look from these people. Of course, I don’t blame them. They’ve grown up on a Warren Buffett “buy-and-hold” philosophy, their long-only mutual funds and pension plans have told them that THIS is the only way for them to make money in the markets. Incidentally, these mutual funds and pension plans, these buy-and-hold proponents are the exact same people who lost devastating amounts in the financial crisis.

There is a group of people who DID make a fortune though, and I can name a bunch of them: Bill Dunn, John W. Henry, William Eckhardt.. and many others. The one thing they have in common? They were all systemic traders. The evidence is overwhelming, yet people refuse to believe it even when I present it point-blank to them. They stick to their beliefs that reacting to news is the only way to make money and that markets are influenced by the so-called “fundamentals”. They stick to these beliefs even though these methods have proven time and again to lose money for most traders. There’s one word to describe a person who keeps acting in a way that harms him: irrationality.

Yet, maybe I want the world to remain this way. Maybe I want everybody to be irrational, to blindly follow those methods that have harmed them in the past. Trading is a zero-sum game, and if they want to give away their hard-earned money, I want to be there to take it. Maybe I want people to be scared of becoming a trader because they think that it’s way too hard to keep up with the unlimited stream of Bloomberg headlines. That effectively eliminates my competition, allowing me to keep doing what I’m doing for a long, long time.


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