- Why Study Market Shocks?
- The Nature of Trading
- Different Perspectives of Trading
- Market Conditions and Sentiment
- Making Trading Decisions
- Looking Ahead
This chapter is from the book
This chapter is from the book
This chapter is from the book
Different Perspectives of Trading
There are many ways of looking at trading. First and foremost, trading is about making money. How you get there is the important question. Trading is about understanding past, and predicting likely future changes in prices. Simply stated, trading is about forecasting.
Trading is also about taking calculated risks. Put differently, trading is about expectancy management—that is, understanding the probability of potential outcomes in a bet. With the exception of arbitrage transactions, all trading entails the assumption of risk. A trading firm expecting to win 51% of the time has an edge like a casino. It might lose on any given bet but should win as the number of transactions increases. The more transactions that are executed, the more assurance the firm has that it will make a profit. Such a firm will think in terms of the volume of transactions instead of the number of trades made over an arbitrary period.
Trading is also about managing risk exposure effectively through risk management: Proper risk management means being aware of all potential risks. This seems obvious but it is surprising how sometimes risks are not well understood even by professionals. Hedge fund managers strive to earn a superior return or alpha for a given level of risk. The financial crisis demonstrated that many hedge funds were not pursuing alpha strategies, where they earned a superior return for a given level of risk, but rather beta strategies, where the seemingly higher return was compensation for bearing risk rather than a source of superior return.
Trading is about decision making, usually under conditions of uncertainty. Traders need to utilize prior information as well as avoid potential decision pitfalls.
Trading is about finding and exploiting an edge or comparative advantage. Where is your trading edge?
Arguably, the most important feature to recognize about trading is that trading is a game. As a game, it is important to understand the strategies and anticipate the likely behavior of other players. Trading entails an element of strategy that depends on what other traders are doing and how other traders will react. Successful trading strategies need to be dynamic as situations change.
Trading is about understanding odds. Although traders would love to place bets where the only outcome is profitable, risk is invariably involved. The secret is not to look for even-money bets, but one-sided bets where potential payoffs are skewed in your favor.
There are a number of popular misconceptions about trading and traders. For example, no one can predict every price move in the marketplace. However, you don’t have to do so to be a successful trader. Most successful traders have more losing trades than winning trades.
What kind of batting average do you need to get into the major leagues in baseball? Many would argue that a batting average of 300 (that is, hitting the ball 30% of the time when at bat) would be enough to qualify. The quintessential discretionary trader, Paul Tudor Jones II, is a member of the Forbes 400—a list of the 400 wealthiest Americans. Yet, he once said that 70% of his trades were losers. How can he be one of the most successful traders if he loses the majority of the time? The answer is that he cuts his losses short and lets his profits run. He is batting 300.
A common misconception about trading is that traders love taking risk. To be sure, risk provides opportunities that traders seek to exploit. However, traders prefer to take less risk rather than more. The ideal trade is what George Soros called “uneven bets,” or trades with payoffs skewed in the desired direction. Some of the most famous trades have been those where the bets were uneven.
Although trite, successful trading entails buying low and selling high, although not necessarily in that order. This is true whether you are trading price or volatility. The rules governing trading are simple. Following them is hard.
The common perception of successful trading is that of a trader identifying and implementing a brilliant trade before a sudden change in price or volatility. For example, John Paulson made $13 billion for himself and his investors from shorting the subprime mortgage market before the financial crisis of 2007–2009. John Arnold became a billionaire after his firm was on the other side of the Amaranth trading debacle in 2006. George Soros is famous for “breaking the Bank of England” in September 1992 by betting that the pound sterling would fall. Paul Tudor Jones II is famous for anticipating and profiting from the stock market crash of October 1987. All of these traders made trading decisions on a discretionary basis by examining the fundamentals (and sometimes the technicals).
The identification of potential trades, the selection of the “best” trade among the set of potential trades, and trade execution are all important. Being right is important, but it is not the most important factor. Arguably, the most important factor for successful trading is risk control. The good news is that sound risk control techniques can be taught.
Most individuals have a bias toward trading stocks. They also have a bias toward trading on a discretionary basis and trading off of perceived economic fundamentals. Most individuals also have a bias toward being long—that is, buying a stock in the hope of selling it later at a higher price. You can make money in up markets or down markets. Restricting yourself to always being long also restricts your potential profitable trading opportunities.