This post was contributed by a guest author, and does not necessarily reflect the views of Richard or MovetheMarkets.com
Let’s Talk About Me
My background as an engineer has ruined my life in so many ways. ;) This comment from Tapeworm’s “Are Futures Harder Than Stocks?” article tells a bit about it:
As far as my “Rocket Scientist” words: Being an RS is such a double-edged sword! Engineering training taught me mathematics, computer programming, problem solving skills and analytical ability. That’s the big plus! When I started trading, I thought I would kill all the dim bulbs out there in the markets. Then they took my “smart” money.
It also taught me about physical laws which deal in absolutes. I can calculate the free return trajectory from the Earth to the Moon. It’s predictable and always the same. There is a “right” answer and an infinite set of “wrong” answers to any problem. Trading is all about probabilities and possible outcomes. I was psychologically ruined for trading by my engineering education! It’s taken me three years of trading just to get to the feeble point that I am today. So I hope nobody ever gets the idea that my degree makes me feel superior to anyone in the trading field. The only degree that counts in trading is earned through experience with the markets, and I look up to anyone who can trade successfully.
I’ll also elaborate on this a bit more: In science, the quest boils down to this:
To be right at any cost.
In trading, it’s the opposite: the quest is:
To make money at any cost–the cost of being wrong, often as frequently as being right!
A successful trader is happy to be wrong as much as 90% of the time, if they are making more money on the 10% of the time they are right. Engineering is a bit different than hard science, with the quest being:
To be right enough, and within a set schedule and budget.
So, it could be worse for me–at least an engineer is forced to inject a dose of practical reality into the equation. But it’s still bad training to go into trading with, and there’s always a huge psychological war going on in my head. Still, I’m a complete science geek. It’s a miracle I got married and had kids, actually. I can’t watch a movie without finding the physics flaws in the special effects. As I wash dishes, I ponder the vorticies in the water flow. I stare out the window on a plane, not at the scenery, but at the wing control surfaces, visualizing forces and vectors. And I can’t stop! Is there a 12 step program for engineers? Naturally, my training has ruined the markets for me, too. I have to take them apart, see how they work, and why. In college, I had to derive the takeoff distance, minimum turning radius and the trim configuration for an aircraft starting from Newton’s second law of motion: F=ma. I end up doing the same thing with the markets. I have to understand why things happen before I can really master something, and I feel like my scatterbrained trading styles have reflected this. So, despite my best efforts to the contrary, I’ve been thinking a lot about why stock prices change. I’ve pondered the following questions, among many others:
–Why do stocks go up?
–Why do they go down?
–If markets are efficient, then why don’t they just change in steps at the release of any news that materially affects the stock?
–Why do stocks even trend at all? Didn’t everybody buy the “first” time?
–Why do some companies miss earnings and go up, while others post great results and go down?
–Why can some markets seem so overvalued, but continue on through the roof, burning all the shorts?
–How could the broad market ever be so oversold that P/E ratios could be in the single digits, so far below “intrinsic” value, as has happened many times historically?
–How could Warren Buffett have ever purchased Walt Disney stock when, after they spent an amount of money on Disneyland that was one fifth the market cap of the company, “it was selling for 5 times rides”?
Richard’s Back to Basics article covers a lot of thought experiments about why stock prices move, and is a great essay for all of the indicator followers out there. It covers a lot of things about price and volume that are important to know. However, my geeky search goes a bit deeper, down to the building blocks of the “F=ma” level.
I studied fundamental analysis a lot in the past, as it seemed to be the most rational, quantitative and precise method for stock valuation. I became disenchanted with it when the markets rose despite my “rationality”. As a neophyte market follower (not yet actually trading) I remember hating on the GOOG after the IPO: “Who would ever buy that company for $100 per share? What do they actually do, anyway? They don’t make any money! Can you say dot com bubble? Idiots!” Well, at about $300 my disbelief blew a gasket, and GOOG went on to hit $500+. But I didn’t make any of that money, and I didn’t understand what was happening, either.
I tried technical analysis in the form of the myriad of indicators. Maybe the tea leaves could tell me what would happen! Again, indicators are often wrong. I was searching for the “right” answer–the always right answer, which doesn’t exist in trading. I realize now that it’s all probabilities. An answer that’s right 70% of the time (in school that’s a C grade, for those counting at home) is awesome in trading! But I still didn’t understand why TA worked sometimes and didn’t other times, and until I did, I just couldn’t let it go.
Enough About Me, On To the Stock Theory!
I had an epiphany the other night while listening to an interview with Jason Alan Jankovsky on TraderInterviews.com. He said that stocks are not a zero-sum game like options and futures. A zero-sum market means that for every position, someone is explicitly long and someone is explicitly short. Every single trade will result in one winner and one loser. This is not the case in equities, where a stock could go from IPO to the moon, and every single seller could be turning over the stock to a new buyer for a profit. Of course this is not usually the case, as stocks do produce losers, but it’s not exactly like the tug-of-war that’s found in zero-sum markets. Stock instruments can exist without anyone holding them, while futures are a contract between two people–one loser and one winner.
Along with the above, Mr. Jankovsky said something else that hit me between the eyes and gave me a big piece to my “how and why” puzzle. In the interview, he said that stocks, which are not a true zero-sum market, are more like a game of musical chairs–whoever is left holding it last is at risk. I’ve read that the stock markets are auction markets, meaning that prices are set by how much someone is willing to pay (best bid), and also by how much someone is willing to sell for (best offer). Musical chairs describes the action in auction markets very well. As long as the music (buying or selling pressure) stays on, then the stock will trend. When the buy music stops, if you don’t have a chair (sold your position), you’re scrambling and could end up on the floor. Stocks should only stop moving and go flat if there is no interest (volume) in the stock. Due to this dynamic, as long as there is interest, there will be movement, contrary to what I had always assumed as I described above! Stupid rational engineering brain…
The musical chairs analogy and the zero-sum clarification made me realize that a terrific example of real stock market valuation is Ebay. Not the stock, the auction service itself. Buying Pets.com at the height of the tech bubble is a lot like somebody buying a cheese sandwich on Ebay for $28,000. You probably overpaid, but not if somebody else comes along and pays more! As long as there is a bull market, people will continue to buy stocks. Why? Because when there is a bull market, people buy stocks! Yes, that’s circular logic, and that’s exactly the principle that underlies equity markets. It’s self-reinforcing. Same on the bearish side. Ebay has some great bargains, if you can find them. Warren Buffet is as wealthy as he is because people lost their heads and sold their stocks for an incredibly low price, and he pocketed 20% of the profits in his partnership. He got Disney for 5 times rides. That’s one way to get 25% compounded annually over 10 years, though you may have to wait the entire 10 years to cash in, so you better be right!
So how do you determine the value of a stock? How do you determine the value of a cheese sandwich with the likeness of the Madonna? They are both valued in exactly the same way: by how much someone is willing to buy or sell it for. Forget the notion that fundamental analysis gives the “true” valuation of a stock. It may give one way to rationally value stocks, but it’s still just a map with its own paradigm; price action is the only “truth” there is in a market. If robot economists traded stocks, then fundamentals are what would move the markets. You can try to use fundamentals to make sure you don’t overpay for a stock, but it’s still not a guarantee. Fundamental analysis is like the broken clock. It’s right twice–not a day, like the clock, but twice in a cycle, when an instrument swings wildly and then reverts to the mean, making a whooshing sound as it passes by. If you missed it, don’t worry–it’ll be back! Pure fundamentalists will sit on the sidelines of an overvalued bull market, watching it climb higher every day, calling every fluctuation to the downside “the bursting of a bubble”. They’ll also buy “value” stocks and stay with them as they crater lower and lower. They may sit for years in a dead stock waiting for the “value” to come to fruition. There’s got to be a better way!
All Right, Egghead, What’s the “Better Way”?
In my humble n00b opinion, the best way to model and trade the inefficient, emotionally charged stock markets is through a probabilistic study of price, volume and related sentiment measures. You can call it “Technical Analysis”, but I see it as different from a black box indicator that may have correlated to past trading results purely by chance. The better way to me is to understand how market participants interact with price, and how to interpret volume into the equation. However, unlike in science, there is no exactly precise calculation or method, and sometimes you’ll get it wrong even when “all signs point to yes”, so to speak. But you can thank that impreciseness for your profits, because that’s where they come from. The price you pay for profits is being wrong sometimes–I can live with that (now, though it killed me in the beginning!). Remember the robot economists? If they were the traders, you wouldn’t squeeze a dime from the markets other than Nominal GDP growth minus inflation, which runs about 3% per year. Mr. Jankovsky said in his interview that he likes to find the time that traders are liquidating their positions at any cost because they were wrong. That’s when he wants to step in and take it off their hands, closing it later for a fat profit. Sounds good to me! I’d love to be on the other side of a lot of my trades, as I’ve been the liquidator many times.
Yadda Yadda. So What Are You Really Saying?
What I’m saying is that the “Musical Chairs” theory is now my model of choice for how traders Move the Markets. It satisfies my need to know why prices act as they do, it addresses the vast divergence of fundamentals and prices, and it incorporates the auction market dynamics that make up each market transaction. Now I need to learn the Musical Chairs game. How to find high probability setups where the music is going to stay on, so that I can get in and make sure I’m not left without a chair (but with a crappy stock). I also need to be able to learn how to tell which is the buy music and which is the sell music if that makes any sense. I’m often buying a breakout that is just a quick blip before price goes the other way, and I end up on the wrong side of the market. Further, I want to be able to read the psychology of traders in the price and volume data, so that I can come in to pick up the cheap goods, and sell them when they are falling all over themselves to get them back. Exactly how will I learn these things? Good question. I’ll let you know when my rocket scientist brain has figured that one out. In the meantime, look for some analysis of this from me in the future, and I hope that others will contribute to this study as well, whether here on MtM or on their own blogs / media outlets.
We now return you to your regular “Alternative Ideas”, already on progress…
This post was contributed by a guest author, and does not necessarily reflect the views of Richard or MovetheMarkets.com
May 27th, 2007 at 8:50 pm
I know this is beside the point, but hasn’t GOOG always made money? According to their SEC filings, they’ve been profitable since 2001.
I actually think that, beyond a certain time frame, stock prices pretty much are wholly determined by the sum of everyone’s forecasted future fundamentals for the company. People ought to be willing to pay as much as the stock will be worth someday, adjusted down by the forecasted risk-free interest rates between now and then.
At the low level where we play, though, there is plenty of wiggle room as buyers and sellers duke it out.
I prefer to not to think about things as if the underlying equations are unknown or imprecise. If you had perfect, honest information about all the buyers and sellers, it’d be pretty simple to tell exactly what was about to happen. The problem is, you only have incomplete, summarized information available, and half the participants are lying, and the other half are irrational. So, the issue’s not with understanding market mechanics, but rather how adept you are at guessing how to fill in the variables you aren’t privy to directly.
It’s good to work from a model that you are comfortable with. Sounds like you haven’t taken the next step and formed plans based on it yet. It will be interesting to see what you come up with, going forward. Good luck!
May 27th, 2007 at 9:01 pm
interesting…looking forward to the rest in the series
May 27th, 2007 at 9:19 pm
Turn rate can be more important than turn radius depending on what tactics you employ in a dogfight. I hope I don’t make you lose any sleep tonight ;).
May 27th, 2007 at 9:50 pm
Prospectus,
Enjoyed reading your thoughts :-)
Equities are zero sum games when you take into consideration opportunity cost. I would even argue a negative sum game due to commissions, spreads, tax, etc.
May 27th, 2007 at 10:29 pm
Even if you pretend that “not making money” is the same as “losing money” I am still not convinced that you can force the sum of the game to 0 in all cases. If I sell my stock to someone for $5 and then it drops to $3, they’ve lost $2. Who made $2 to offset their $2 loss, in that case? Do you have to add a “reverse opportunity” gain for me because I avoided losing the $2 by selling when I did?
Or imagine if the stock price just didn’t move. It’s pegged at 15, say. Now, whoever bought it under 15 made money, but there’s no opportunity cost for selling anymore, and the people that they sell it to won’t show a profit or a loss beyond commissions. The total for all participants won’t add up to 0, right?
The stock markets act a lot like a 0-sum game, but it seems to take a lot of intellectual maneuvering to force them to be one. Compare that to a futures market, where you always know who made money and who lost money, and it always trivially adds up to $0.
May 27th, 2007 at 11:13 pm
This same analytical mindset is killing me right now. I’m not an engineer, but I have a computer science background and repeatability and determinism are vital. In order to prosper in probabilistic environments, I’ve convinced myself that there are setups which come with a positive expectancy. If this is the case, then it should be a matter of precisely following a defined set of rules and relying on the odds to be in your favour in the long run. In blackjack, the casino will lose a lot of hands, but if they just follow the rules to the letter, in the long run they will win big. I figure trading is like that.
The only problem is that day trading is rarely a simple matter of following a defined set of rules and expecting to make money. There’s a lot of judgment, intuition and feeling and I’m having a very hard time with that. Making money or losing money isn’t enough since, I always want to know if my actions would have made money in the long run. It’s like wondering whether you should change the rules of blackjack every second hand.
As for non-zero sum, that argument only works over the long term, and day traders are actually a negative-sum game. At best, day traders must be zero-sum (we essentially trade with ourselves since, for every day trade purchase there must be a day trade sale) and so the game becomes negative-sum with commissions.
May 28th, 2007 at 12:20 am
@Tyro: When I daytrade a stock from $15 to $15.10, I made $.10 per share. If it’s a zero-sum game, you have to be able to find the person(s) who lost $.10 per share. Where are they? Similarly, when I have a losing trade from $15 to $14.90, who made $.10 per share? Not everyone you buy a share from is shorting it to you. It’s just not a zero sum game, is it? How do you make it add up to 0?
May 28th, 2007 at 6:09 am
Prospectus,
very interesting post. My own experience is that the best traders know how to mix rationality with a strong psychology, ie: they truly accept that trading is a probability game (and hence don’t try to be right in any given trade). This is more profound than what it looks. What it means is that you have to deeply accept that you will have no control over markets whatever your methodology is, the only thing that you can pretend to do is to catch the big moves as they occur and always cut your losses !! Being an engineer is certainly an handicap in the sense since you were rewarded when applying proved solutions to defined set of conditions…. this is simply not the case when dealing with markets… Learning how great traders master their craft is probably more important than trying out new ways of looking at markets…
Good luck in your development as a trader !!
May 28th, 2007 at 6:29 am
people buy and sell stock for a multitude of reasons…sometimes they sell without any regard for the future price of a stock…i.e., they may sell shares to come up with a down payment for a house, or go on vacation
whether or not stocks are a zero sum game is immaterial…the only thing that matters to a trader is his P/L…if u are in a trade that is rapidly moving against u, is it any comfort that the market rises a certain % on average per year?
May 28th, 2007 at 10:39 am
To me it matters to have it straight in my head, because it helps gauge how many people are hurting (and, sad but true, it’s when people are hurting that you can make the easiest money). When a stock is dropping, all the volume above that level is unhappy, and some percentage that were short sellers are happy. Since the short % is always less than 100%, there is always net pain when a stock falls through thick support. On the other hand, when a stock is rising, there is always net happiness because only the short sellers below that level are hurting. In a zero-sum market, the picture would be a lot more symmetric.
May 28th, 2007 at 10:48 am
richard: its that very fact that should propel u to the futures arena…futures traders in a losing position are forced out…stock traders can hold their losses until it reaches zero
May 28th, 2007 at 10:50 am
richard: its that very fact that should propel u to the futures arena…futures traders in a losing position are forced out…stock traders can hold their positions until they are worthless
May 28th, 2007 at 10:54 am
john: a point so nice, you made it twice :-) yeah, I’ve been thinking the same thing, off and on.
May 28th, 2007 at 11:03 am
@Richard
I tried to answer, but it just grew too large. I didn’t want to give you a hand-waving answer, so I spun it off onto a post on my blog. Here is my answer.
May 28th, 2007 at 12:30 pm
Thanks, Tyro. Like I said on your post, I think you have sound logic going on. But, you’re really talking about how the net daytrading effect tends to be small. You aren’t really proving that it’s always zero (or negative). Surely you can agree with that? A zero-sum game has a simple and precise definition, and the burden of disproving it is a lot lighter than the burden of proving it.
May 28th, 2007 at 2:36 pm
richard: oil might be a goood instrument…that’s where i reside, and i’m an easy mark :-)
May 28th, 2007 at 2:59 pm
@Richard - I agree with that. Day trading can be positive, zero or negative in specific instances.
May 28th, 2007 at 5:49 pm
@john: lol
@Tyro: now that I’m off the zero-sum thing, I am enjoying thinking about things in terms of the model you outlined. Especially about the big block players in their side-markets.
May 28th, 2007 at 9:01 pm
@Richard - you’ve convinced me that day trading doesn’t need to be a zero-sum game and the more I think about it, the more I wonder just how far away from zero-sum it can get and whether there are variations during the day.
I also wonder if there can be any advantage in knowing that day traders seek to exit their positions by the end of day.
Let us know if you come to any conclusions.
May 28th, 2007 at 9:21 pm
it sure seems like it’s an advantage, but I’ve so far only made a handful of trades with that idea in mind. You know, if you imagine that most daytraders are short, then the stock really should bounce a little at the end of the day, as they cover their positions. Things like that.
October 6th, 2007 at 2:33 pm
I think you are missing the forest for the trees. Daytrading is not only a game against other daytraders. It is a way to prop up the market day-to-day. Daytraders are just a small part of the forest. Daytraders buy/sell their shares not only to other daytraders but also to mutal funds, long term investors, market makers, pension funds, etc. Thus daytraders help keep the market humming along and enable the stock market as a whole to retain volume. This causes the price of shares to increase or decrease on a daily, weekly, yearly basis thereby increasing the pie as a whole. Anything with a growing pie can not by definition be a zero-sum game.
As far as the mechanics of the stock market, I always think of it as a big clock. The clock ticks away because of the gears within the clock and the power source that moves thoses gears. You have big gears and little gears each interlocked and moving due to other gears action. The power source of this clock is the energy of the country. During good times the energy of the people is alive and vibrant and this causes the gears (i.e P/E to expand) to move faster. During recessions the power source is low and the gears(P/E) slow down. If you wind up the power source through things like tax cuts, Fed cuts the gears will increase and if you drain the power source through tax hikes, high unemployment, high interest rates the gears will slow. Each gear (market sectors) have many smaller gears (stocks within the industry) that power that gear. The more those gears turn (rev) and the faster those gears turn (rev growth) the more powerful the big gear(market sector) will turn. The gears in turn are made out of the different metals (fundementals) some are made out of weak rusted steel and some are made out of stainless steel. The metal determines the strength of the gears and the velocity that those gears can turn before they break (bubbles and busts). Now every clock needs a clock maker to keep it running correctly. The market’s clock markers are the exchanges and SEC. The tools they uses to fix the clock and replace the gears are rules, regulations, IPO’s and buyouts.
Since the clock is so big and has so many different gears it becomes like the butterfly in China problem in Choas theory to predict on a consistent basis the moves of the market (subprime is a good example) Therefore we humans have devised many and varied ways to find out the next move of the clock. However the nature of the clock makes those ways only good for that single PERIOD of TIME and thus those that insist on using one size fits all methods are doomed to lose. You must be nimble and move with the flow of the gears and worry less about how and why those gears move. It is enough to know that they move. Sure you may be able to understand some parts of the movement and the smaller the time frame the more clearity of the near term future you will see but trying to understand the entire clock is a sure way to get committed into the funny farm.
October 7th, 2007 at 10:45 am
Thanks for the comment, Bill! Interesting analogy.