In typical form, Barry Ritholtz has written a provocative, popular, and controversial piece entitled “Are All Traders Useless Morons?” No matter what your investment strategy, you should read it.
The argument is that the upside from short-term trading is mind-boggling, and several orders of magnitude beyond the best traders, even the one who turned $10 million into $100 million last year betting against gold. A 900% return in one year is pretty good, but nowhere near the hypothetical maximum.
So traders, no matter how well they did last year, need to improve their game, as Ritholtz says:
“Second, even the best traders must constantly seek to improve their skills, knowledge and tactics. The markets are an ever-changing environment; what worked last year may not necessarily work next year. Given how much of that 26.4 billion percent Alpha you left on the table, there is plenty of room for improvement.”
Arguably, what separates the professionals from the novices isn’t their job title, their AUM, or their returns, but their focus on improvement. The professionals know that billions of dollars of profits are lost every year from inefficient human traders, and so they constantly work on improving their performance. They do not brag about their accomplishments, because, no matter how good it may seem, it isn’t as good as it could be.
Before considering how to improve one’s trades, a trader first needs to consider what happens when they hit “buy” or “sell” and how short-term and long-term time horizons are essential to producing alpha.
Trading, Investing, or Both
For many value investors and proponents of an efficient market, trading almost guarantees losing money. 900% returns notwithstanding, an efficient market means that all available information is baked into stock prices, and trading on the basis of speculations about price changes will yield a lower profit than long-term investing. This is Warren Buffett’s argument, although he by no means believes in an efficient market.
The Buffett argument rebukes retail day traders who believe that they can outperform the market by staring at charts all day and predicting changes based upon patterns. This belief is encouraged by stockbrokers who earn commissions on individual transactions, which partly explains why retail discount brokers have offered better and better self-service charting tools at a time when high-frequency trading has made it harder for individual traders to predict short-term stock movements. But even before HFT, as this study shows, most day traders lose money after transaction costs.
At the same time, the study above admits that a small group of day traders do quite well. The experience on Wall Street over the past few decades confirms that: the best traders at the best global macro and long/short funds have earned strong risk-adjusted returns. They do not do this by sticking to day trading and predicting movements over a few seconds or minutes. Although technical analysis plays an important part of their analysis, there is much more involved. To beat the market, traders don’t stick to short-term trading or long-term buy-and-hold investing. In reality, they do both.
How Professional Traders Trade
Every desk at every institution is different, and they need to stay different to yield alpha. Each firm has its proprietary strategies and individual trading methods that are a combination of qualitative and quantiative data regarding macro, micro, and technical trends. But these idiosyncrasies exist within a consistent approach to the market that can be dissected into the following components:
- Idea discovery. The first step, usually taken by analysts, is discovering which names to focus on. These can be chosen based on a number of factors, but are usually identified as having greater potential for upside and downside movements due to changes in the company’s revenue and earnings potential.
- Modeling the future. Secondly, the analysts will work with portfolio managers to develop models that map out the future of the company. These “models” are really just complicated spreadsheets which layout companies’ expected future quarterly revenue, expenses, and earnings.
- Due diligence and model tweaking. It’s easy to fill in these figures for past quarters, but what about future quarters? This is where due diligence comes in. Analysts continue to read, listen, and learn about the company they are focusing on, and they try to make compelling arguments for more accurate numbers to put into future quarters on the model.
- Stock price targets. A model will include upside and downside cases, which should yield projected stock prices. Since stock prices are supposed to reflect the number of outstanding shares, the revenue of the company, its operating margin, and the future growth rate, projecting how these numbers will change will yield future potential price targets. Institutional investors develop models that have set bullish and bearish price targets. Say, for instance, a group working the telecomm desk at a fund yields price targets for T-Mobile (TMUS) that go from 12 in the most bearish case and 20 in the bullish case. The models have yielded a range.
- Swing trade the range. With the model in place, traders have their price targets. Now they will swing trade the name, going in and out as it goes from one point in or out of the range to another. For instance, if TMUS is trading at $11, the analysts’ model signals a buy, so the traders will buy. If it gets to $21, it’s overbought, and it’s time to sell. If something changes in the company that requires new price targets, the traders will swing trade accordingly. if TMUS reports greater than expected growth, then the analysts may raise their price targets to 15 and 25. That’s the new range for the trader. If the trader has already sold the stock at $21 before the analysts raise their target to $25, the trader will buy the stock again, even if it costs, say, $22 or $23.50.
This is not buy and hold, but it isn’t exactly random short-term price prediction either. It’s making reasoned and short-termed trading decisions based upon a hypothetical expectation of the world. It is buying and selling items of value at a higher level of abstraction than the marketplaces of the past, but it’s the same idea. Traders who do this effectively, in tandem with analysts who make accurate models, will yield tremendous profits for investors. The tricks are timing the trading right and getting the price targets right. While no one is perfect at this, everyone is always trying to get better.