Alpha isn’t just about finding people willing to trade at bad prices.
Although that’s a necessary condition, it’s not enough.
We also need to know why people are willing to buy too expensive or sell too cheap. The reasons are pretty simple:
- Some traders don’t know any better, while others have biases that make them chase returns or anchor to past prices
- Some traders are operating under constraints – they have to trade because of their risk limits, mandate, systematic rebalance rules, investor redemptions, and so on.
- And finally, some traders have other incentives in mind, like wanting to window-dress or manage their annual performance reporting cycle.
The first reason requires the existence of other uninformed traders, or what some people call “dumb money”.
But it wouldn’t be wise to chase this “dumb money alpha” because that would require competing with the big players. There is a lot of competition for dumb money alpha, and it doesn’t make sense for the indy trader to go up against the best, most well-capitalized traders in the world.
However, even “smart money” traders can be forced to do things they don’t want to do because of the constraints they operate under. These constraints create opportunities for us.
So instead of chasing competitive dumb money alpha, we need to find opportunities where there isn’t a massive amount of competition. For example, we could look for opportunities where the flows are too unpredictable and massive to be fully absorbed or where the opportunities are too small, noisy, or scummy to be worth the big boys’ time. Maybe these opportunities involve taking on nasty negative skew or risks that are hard to hedge.
The point is, our bread and butter as indy traders is uncompetitive, unattractive alpha arising from people willing or forced to trade at bad prices.
Massive, noisy flows that are slow to converge are a great place to start. Think end-of-month rebalance trades by big pension funds. They’re typically simple to understand and harness and unlikely to be arbitraged away by sophisticated players due to both the size of the flows and the noisiness of the edge.
And while trading noisy edges might not sound like much fun, the reality is that as indy traders, we must eat what we are fed. We must take the opportunities that are realistic for us to harness, not the ones that are out of reach.
We must embrace the mindset that these opportunities exist for us precisely because they’re unattractive.
Having said that, it’s also possible to stack multiple noisy edges on top of one another and get a far less noisy result at the portfolio level, to the extent that your edges are uncorrelated.
If you want to learn more about how to find, analyse, and trade such opportunities, consider joining the waitlist for the next run of Trade Like a Quant Bootcamp, our twice-yearly Bootcamp on the fundamentals of getting an edge as an indy trader.
