by in Public

So You Think You Can Trade?

logoAnonymous blogger Zero Hedge is getting his 15-minutes. Big time.
“Tyler” was on Bloomberg on Monday discussing “trading” done by Goldman Sachs:

[mp3]https://www.impossibleportfolio.com/wp-content/podcasts/20090720.zerohedge.mp3[/mp3]

I have said many times before that focus on very small time frames is often counterproductive because of a host of issues, including slippage and commission. And now you know that you are also competing with GS on the 1-minute or 233-tick chart. Remember, their algorithms are not “trading” per se. They are essentially making the market, matching buys and sells for a handsome profit.
Now that the market been rising for a few months, we have probably entered a phase where a lot of lucky people will conclude that they are smart. At this point, traders are probably going wild with small-caps, penny dreadfuls or deep out-of-the-money calls, but wait, is it a good idea to bet on black swans? This dangerous illusion is exposed in Eric Falkenstein’s book.

In my book Finding Alpha, I argue that people tend to pay for hope, and nothing offers hope better than the lottery-like returns available in potential Black Swans. Hope is a good thing, and motivates a lot of hard work and creativity. But it would be foolish to think that the more improbable, the more speculative, the more derided by economists, the better the risk-adjusted return merely because of this. This tendency to buy into lottery ticket leads to all sorts of really bad investments:

  • Higher volatility stocks have lower return than low volatility stocks
  • Higher beta stocks have lower returns than low beta stocks
  • out-of-the-money options have lower returns–and higher betas–than in-the-money-options
  • higher leveraged firms have lower returns than lower leveraged firms
  • firms is greater financial distress have lower returns than firms with low financial distress
  • Junk bond mutual fund returns are lower than investment grade mutual fund return over the past 22 years
  • sports longshots such as 50-1 odds horses, have lower returns than favorites
  • lotteries with the highest payouts have the lowest expected returns
  • IPOs have lower-than-average stock returns

[This is in my book, and also summarized on an SSRN paper I wrote here.] Notice a pattern? The more volatile, more uncertain, the lower the return. People pay a premium (accept a lower return) for ‘Black Swans’, because in one fell swoop, they can get rich and prove they were RIGHT! Instant satisfaction. Plus, if you really have the touch, why waste time choosing Coke over Pepsi, when you can choose between GM and Citi!
Basically one would be better off not chasing dreams via Black Swans, and stick to boring investments. Finding alpha–a risk-adjusted return premium–is very difficult, and it involves a niche specific to an individual’s skills, which almost surely is not in investing anymore than the average person has alpha singing or writing romance novels. Black Swan investing is a sucker’s game, endemic in markets, a perennial loser, and highlights asset classes to avoid, not pursue.

Retail traders and investors generally use a lower bar to measure performance: it must make money. Until it doesn’t. Then they say the “market has changed” and go back to square one.

6 Comments

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  1. A daytrader/ spreadbetter in the UK, this guy made GBP 300,000 last year- yet on his worst day so far this year, he lost GBP 200,000! Risk/ reward a bit skewed.

  2. I’ve been getting screwed! (on loss days)…that’s market timing with a better tool…I want one

  3. In addition to my comments under No Shit Sherlock! and as follow on, I heard a very bright and industry smart fellow on “Fast Money” explain how Goldman Sachs with their proprietary software, which was nearly stolen from them last month, can make a $100,000,000 million dollar trade where they are in and out of the market in five minutes!! Their software is able to detect the smallest imbalance between assets (arbitrage) to take advantage of the situation. If this is done a few times a day, it’s same as a body blow where the market cannot get its wind back. Do this in ETFs and some will just reel from the hit. I understand the reality of the word “fair”, but is this good for the general market?
    let me put in another way….
    To Ms Lo Head of the SEC
    “Ma’am, do you feel that Goldman Sachs proprietary methods along with other trading companies helps create an orderly market? Please explain..
    Senator Robert
    Finance Committee

    • Eric Falkenstein has weighed in on computer trading:

      Several bloggers have made a big deal out of ‘flash trading’ article in Traders Magazine, where exchanges give priviledged access to order flow, letting them accept or reject these trades prior to hitting the general market. Normally this would upset me, but they have an option lasting only 30 milliseconds (30 thousandths of a second). For a computer, this is enough time to make a decision. This is certainly enough time to make a tenth of a cent or so on market orders by leaning on the existing book. That is, if the market is bid-ask at 10.03-05, with 100 shares on each, a market order to buy 100 shares might make you hit the offer at 10.05 because you know there is 100 shares following you, and you hope the price increases based on this flow. This is known as ‘front running’. Or you might see more buying coming in at a limit price of 10.02, and decide to increase your bid at 10.03 because you know your downside is now limited to a penny, as you can sell at 10.02 in size. This is known as pennying a bid, because you basically use the other person’s limit orders as a backstop, giving you a penny downside risk. As tendencies move probabilistically, on any one trade such shenanigans are worth much less than a penny, but it can add up for the one doing it. For your average investor, in contrast, it is totally irrelevant. In the context of buying a $20 stock, does the fact that a highly competitive group can make tenths of a cent on market transactions bother me? No. It is orders of magnitude lower than 10 years ago, which is orders of magnitude lower than 30 years ago. Commissions for most investors are at least a penny. Of all the financial skullduggery in the world today, Flash Trade front running worth a fraction of a penny is small beer.
      . . .
      Basically, people who do not understand a market where some participants are making a lot of money are often eager to call for regulation of that market because it seems obviously unfair. The solution, however, is invariably to merely entrench a status quo with a bigger shield against competition, but one where the profits can be shared equally by the exchanges, their member firms, and their regulators (through revolving door employment at the top ranks between exchanges, firms, and government). There was little ‘change’ on the exchanges prior to the 1990 computer revolution, and they robbed the public blind the whole time because they had a monopoly on order flow, al the while lecturing their friends at the country club about their deft risk management skills and financial acumen.
      Leave the market alone. It is very competitive, and if some electronic exchanges have different rules where people feel their orders are treated more fairly, volume will flock there (there are about 5 electronic exchanges). Competition is the best regulator ever invented. If you think someone making a tenth of a cent on your order is a big problem, you trade too much.

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