Your job, as a trader, is to take all the information we have available now and make a judgment on whether something is trading at the right price or not, given things you can know here:
Is it the wrong price? Can we buy it too cheap, or sell it too rich?
Let’s say we think it should be trading here:
In this case, we’d say it was too cheap. You might, for example, think it’s cheap because you suspect some maniac is coming into the market with big buy orders that are likely to push prices up.
Now, in this case, assuming you had some way to predict that, you’d think about buying it ahead of him. And then the selling it to him towards the end of his buy program.
However, if you have seen this coming, others will have seen it coming, too.
If you think this guy is about to start buying, and you’re right, you’ll see other traders rush to buy cheap too, in anticipation of selling to this guy.
This will tend to push price up such that the expected impact of our maniac’s buying gets incorporated into the price very quickly.
This competition is why the market is so efficient.
And it’s why the existence of crazy price-insensitive traders isn’t enough for us to have an edge.
We might know this guy is willing to trade at bad prices, but that doesn’t mean that we are the ones who get to trade with him.
Trading with him is a competitive business.
It’s highly competitive when we’re right about the trade.
This is a blessing and a curse. The blessing is that this aggressive competition makes market pricing very efficient. So, in a liquid market, it’s hard to trade at bad prices, even if you’re trading without an edge. You get to trade at prices set by the most informed players.
This implies that the part-time independent trader, who is constrained in myriad ways compared to the big, well-capitalised professional teams, should seek out the places where there’s the least competition.
And we do that by looking for “win-win” games where there isn’t really any competition. For example, risk assets tend to always be cheap on average compared to their expected total returns – we can take advantage of this risk premium without really eating anyone else’s lunch.
And we also do it by looking for games like this trade-with-the-maniac game that are unattractive to others.
For example, in this case, we’d like fewer people here trying to play this game so we can still get a piece of it even if we’re not the quickest.
But for people to not be interested, the opportunity needs to be unattractive in some way.
Don’t ever get too impressed with yourself and think you’ve found something nobody else knows about… that’s unlikely. You want to know what sucks about it and be prepared to accept and manage that.
And there will always be something that sucks about it.
For example, maybe this is a micro-cap stock that few are willing to pay attention to because the risk is high and the opportunities are relatively small.
Maybe this maniac guy’s buying is a pretty random, hard-to-predict thing – so the trade is quite noisy. Subject to a lot of luck. So it’s not a good use of risk capital for smart money vs other less noisy trades.
We want these things to be unattractive and uncompetitive.
In Trade Like a Quant Bootcamp, we go through tons of examples of what edges in the market look like – some competitive, some uncompetitive. The idea is to lay out a map of the trading landscape and help you pick out the trades that you can realistically participate in.
So, to summarise:
- You are in competition with other traders.
- To make money, you need someone to be prepared to trade with you at the “wrong” price.
- And you need to be able to take advantage of it in a competitive environment.
- The immense competition means two things:
- It’s hard to make money trading unless you pick your battles carefully in uncompetitive places.
- But it’s also hard to make bad buy and sell decisions because you get to trade at prices set by the smartest in the business.
- Good trades for the independent, part-time trader are generally uncompetitive ones. Trades are uncompetitive because they’re either:
- Win-win (someone doesn’t have to lose for you to win) – such as risk premia harvesting
- Unattractive to the big players in some way – maybe they’re noisy, capital-constrained, tend to have a skewed return profile, or operationally awkward.