Stock trading

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The difference between “trading” and “investing” can be somewhat arbitrary, and can be related both to the holding period and the purpose of the stock purchase. Traders attempt to make money from short-term changes in stock prices, whereas long-term holders can make money from the long-term growth in the economy.

Sharpe’s arithmetic

One of the major theoretical arguments against active trading is Sharpe’s “The Arithmetic of Active Management”,[1] which argues that active traders, when taken as a group, must underperform the market (provide less return) by the fees involved in trading. Nonetheless, although the traders as a group must underperform, this argument implicitly assumes that there will be a small group of outperformers (provide a greater return).

Poker chip stack size

Assume that a game of chance – say, a coin flip – occurs between two players. One player has a stack of 10 chips, and is assigned “heads” on the coin flip. The other player has 100 chips, and is assigned “tails”. Each player antes one chip for the coin toss. The probability of the first player experiencing a run of bad luck from the start of the game and running out of chips is 1 in 210, or 1 in 1024. But the second player has only a 1 in 2100 chance of running out of chips from the start – about 1 in 1030. Thus, the second player has a far lower risk of running out of money because of his larger chip stack.

When trading stocks in the stock market, the individual investor has a much smaller chip stack than does the market in aggregate, and thus is at greater risk of running out of money. As the quotation attributed to J.M. Keynes stated in a slightly different context states,[2] “Markets can remain irrational a lot longer than you and I can remain solvent.”

If one chooses to play poker, one should have some understanding of betting theory, i.e., money management:

For a speculative investor, there are two aspects to optimizing a trading strategy. The first and most important goal of a trader is to achieve a positive expected risk-adjusted return. Once this has been achieved, the trader needs to know what percentage of his capital to risk on each trade. The underlying principals of money management apply to both gambling and trading, and were originally developed for the former.[3]

Institutional trading desks

Many financial institutions have trading desks. Since stock trading is essentially a competition, the individual trader must realize that he is working against several better-bankrolled (and possibly more experienced) opponents at once.

The "small person" advantage

Institutional traders need to take large positions in order to make money for their institutions. Large positions cannot be taken in thinly-traded stocks without affecting the stock price and negating the chance of a trading profit. An individual trader may therefore be able to take advantage of inefficiencies in thinly-traded stocks or preferred shares where the available profits are beneath the notice of institutional traders.

Academic studies

One of the more important academic studies on individual trading activity was entitled “Trading can be dangerous to your wealth”,[4] and concluded that individual traders underperformed the market by over 6% from 1991 to 1996.

Successful traders

A number of individuals have made (and sometimes lost) a fortune by stock trading. Some of the more famous names can be found on Wiki.

To trade or not to trade?

The decision whether to adopt a trading strategy is an individual one. The rewards of successful trading are potentially very great, despite the risk. Although many firms offer proprietary trading software or trading courses for a fee, one wonders why, if their system is successful, they have not retired to an island paradise rather than continuing in sales.

Anybody considering trading as a career may wish to consider the following points:

  1. Practice your system (whatever it might be) before attempting to implement it with real money.
  2. Decide in advance how much you are willing to lose and understand that it is psychologically difficult to realize a loss[5].
  3. Remember that beanstalks don’t grow to the sky and very high returns cannot be sustained over the long term.
  4. Recall that leverage (i.e. borrowing to invest) is a two-edged sword that magnifies losses as well as gains.

The Stock Market Crash of 1929 was felt to be in part to be due to excessive use of leverage.[6]

Trading and human behaviour

You may buy a trading system or develop your own, then test it extensively using out of sample data[7], and then paper trade it extensively but you cannot simulate the emotional aspects of trading. Behavioural finance [8] is an area of research worth examining before proceeding with trading. Specifically, one should become familiar with[9]:

  • Anchoring: Setting a price by choosing an initial value (such as purchase price) and adjusting from that
  • Loss aversion: Placing more value on avoiding loss than on making profits
  • Framing: Relying on your own experience when trying to answer a question rather than looking at the facts objectively
  • Overconfidence: Generally thinking your are better at trading than you are, and so trading too much
  • Sunk cost fallacy: Trying to justify a past bad decision by putting more resources into it

The trading system may be rational but the trader may be irrational.

References

  1. William F. Sharpe, The Arithmetic of Active Management, The Financial Analysts' Journal Vol. 47, No. 1, January/February 1991. pp. 7-9
  2. Wikiquotes, J.M. Keynes, attributed quotes
  3. Martin Sewell, Money Management
  4. CiteSeerx, Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors
  5. CiteSeerx, Are investors reluctant to realize their losses
  6. Wikipedia. The Great Crash (1929), J.K. Galbraith.
  7. American Stock Exchange, Out-of-Sample Data
  8. Martin Sewell, Behavioural Finance
  9. Financial Times, Decoding the psychology of trading