The Number One Job Of A Trader

Thank you for your replies to my question: What is the number one job of a trader?

Your answers tended to revolve around making money, managing risk, protecting capital and making positive risk-adjusted returns. Those are all good suggestions that make sense. I would add that in professional trading firms, acting in compliance with the law and regulations is an explicit focus as well.

I think the real answer is deeper. For me, the number one job of a trader is to be allowed to play the game again tomorrow.

Why? Because it is a probability game, and the only people who are right every time deserve to be in jail. Even when you have a good edge, the odds are that there will be reasonably long streaks when the dice simply do not land your way. It is important to develop an edge (a positive expectancy), but it is equally important to be in business long enough to capitalize on that edge.

Take the example of a weighted coin, where you win 2x your stake if it comes up heads, and lose your stake if it comes up tails. You have $100 to play with, and the game will be played multiple times. How much should you bet on each coin flip?

The answer is clearly not $0: this game has an edge (a positive expectancy), so you should be willing to play it. However, the answer is clearly not $100  either: there is a reasonable chance that you will lose on any given coin toss, and so you should not risk your entire stake on one flip.

Smarter people than me can work out the math of what the “optimal” bet size is for this game. In the real world, the game is murkier since you do not know what the odds are: you can only make educated guesses or rely on historical back testing. The important point is that you need to act so that you can play the game again. Betting too big so that you blow up before the positive expectancy can play out in your favor is a fatal mistake.

Acting in a way that stops you being able to play a positive expectancy game again means that you have failed as a trader. This covers everything from losing so much money that you blow up/get fired, breaking any laws or codes that get you banned, or sleeping with the boss’s wife: anything that stops you being allowed to play the game again tomorrow. It doesn’t matter how good your trade idea is, or how much money the trade is going to make next week, or how good your average win/average loss ratio is: your swipey badge thingy has to open the door to the trading floor tomorrow.

You need an edge to make money over time. But if you have an edge, and you act in such a way that you cannot exploit that edge, you have failed.

The Difference Between Trading and Investing Is Liquidity Risk, Not The Time Frame

Sometimes when I try to engage with people about what I do, I get the response, “That’s great for you, but I’m an investor not a trader.” Normally they follow-up with something like, “I don’t trade. I invest in value stocks for the long haul.”

The difference between trading and investing is a murky continuum. A common approach is to focus on the time frame: investors focus on positioning themselves for the long haul, looking to earn a return over many months or years, whereas traders are hyperactive chipmunks who can’t hold a position for more than a minute without seeing another nut to chase. Trading is short-term, investing is long-term.

I think that this approach takes attention away from a crucial and often forgotten part of the process: The need for someone to take you out of your transaction. I think that if your plan involves eventually selling your asset to someone else, whether that is in 8 seconds or 30 years, then you are trading not investing.

Why is this so important? Because once you need someone else to take the asset off your hands, you cannot ignore considerations of what that person is thinking, how they might value the asset, and how they are financially and psychologically positioned. Those are considerations and risks that are better handled in a trading methodology than an investing one. Investing methodologies tend to assume that asset prices will revert to “true value” over time. Trading methodologies know that markets can stay apparently disconnected from fundamentals for long periods of time due to the needs, position and psychology of market participants.

My definition of trading is broad, and encompasses many things typically regarded as investing by most people, e.g. buying equities under a 401k. If you “invest” in the stock market this way, you do not eat the stock certificates in retirement. Instead, you plan on selling those stocks to someone else i.e. you need another monkey to be willing to acquire your portfolio when you want to extract your money. The price at which they are willing to acquire your portfolio from you will materially depend on their circumstances.

There are things that still count as investing by my definition, and they typically involve coupon-like cashflow. Buying a bond to hold to maturity, for example, is an investment: provided that no-one defaults, you get your money back plus interest i.e you do not require someone else to buy the bond from you. The cash-flows do not have to be guaranteed:  building a factory to manufacture widgets is an investment (building a factory to sell to someone else is a trade). Buying an oil field to pump the oil out is an investment (buying oil futures is a trade). Buying an equity solely for a dividend payment might be an investment, but hardly anyone buys an equity and holds it in perpetuity solely for the dividend: most people assume they can count on getting their capital out at some stage as well.

You can also consider this as liquidity risk. If you need someone to “take you out” of a position in order to make a return, then you are exposed to liquidity risk i.e. the risk that the market may not be able to buy at the time you wish to sell, and vice versa. Different asset types have different liquidity risks: holding a bond to maturity has all sorts of risks (e.g. credit risk) but does not have liquidity risk. Buying stocks for capital gains does entail liquidity risk even if you do not need someone to sell to until 2062.

I am aware that most people are not going to consider a retirement portfolio held for 30 years as a “trade”. However, defining the difference between trading and investment in terms of liquidity risk can focus attention on a crucial and often forgotten part of the process: the need to have someone to buy or sell whenever you want or need to liquidate. There is a considerable risk that the market may not want to transact with you when you want to, and certainly not at the price you might want to transact at. And certainly not if you happen to be part of a larger than usual generation that is all liquidating a similar portfolio at a similar time…. cough baby boomers cough cough.

For my next post, I would like some audience participation please. What is The Number One Job Of A Trader? Please post your answers below, or using the Contact form. Thanks.

Trader 101

I am a professional trader. I seek exceptional risk-adjusted returns. I try to grow my money faster than the risk-free interest rate, whilst avoiding the large draw-downs associated with the traditional investment styles e.g. “buy-and-hold”, “60/40”. Specifically, in my personal accounts I aim for returns of 30% or more a year, while limiting draw-downs to less than 10%. I look to compound these returns over long periods of time.

I trade to make money. I do not trade for excitement, ego-validation or self-justification. For those things, I drive my car really fast, I jump out of airplanes and I have a loving family to tell me that I am awesome. Knowing why you do something, and being honest with yourself about it, is important. In Market Wizards Ed Seykota says, “Win or Lose, everyone gets what they want out of the market”. The market will give you what you want, so you have to know what you are really after.

You need to know who you are, and your place in the market ecosystem. Markets are made of a wide range of participants: market-makers, hedgers, institutional investors, investment funds and speculators. I am a speculator. Speculators have one chief advantage over other market participants: they can choose how and when to engage the market. Other participants, to varying degrees, have to be in the market all the time whereas speculators can refuse to participate until they see the right opportunity.

Since you have the freedom to choose when to participate, it is important to take advantage of it. This means being agnostic regarding market direction. I have no inherent bias towards any market: I can be long or I can be short. I can be long one day and then short the next. I have been known to flip my market position and opinion on a dime as the market conditions demand.

I am both incredibly fickle and incredibly loyal. If a market is kind to me and my position is making money, I can be loyal until the end of days: I will wine her, and dine her, and perhaps even sixty-nine her. If a market turns on me and treats me bad, I become incredibly impatient and move on to the next good thing.

Large, liquid, transparent public markets provide a wide range of opportunities to achieve my goals. These markets are very efficient mechanisms for transferring wealth from the many to the few. Most market participants lose money: in order to make money you have to do what other people do not do. Since most people do what they find psychologically easy, to make money you have to do things that are psychologically difficult.

Like most traders, I struggle to do what is difficult, to trade the plan, to control my emotions. Along the way, I have learned some tricks, some strategies and some road signs in the mist. The next few posts will explore some of the difficulties of being a trader, and some of the solutions I have picked up.

What Is The Zikomo Letter?

Like all of us, I play many roles. I am a father, a husband, a son, a friend, a lover, a neighbor, an employee and a citizen. For this blog, however, I am a trader. I trade professionally for a large commodities trader, and personally for my own accounts.

The focus of The Zikomo Letter (ZSL) is on trading. Once or twice a week I post on trading, investing and personal finance. These are my thoughts and convictions, argued with passion and hopefully intelligence and humor.

In real life, I am actually reasonably humble, appreciative of nuance and incredibly grateful of my good fortune. That is unlikely to come across on this blog. I encourage you to disagree and debate with my assertions: I am often wrong. I read widely and borrow liberally, and I try to acknowledge sources where appropriate.

I am not a financial adviser or a fiduciary of any sort. Nothing I write should be taken as advice regarding the suitability of any particular security or investment strategy for you. At times I may hold positions in trading instruments mentioned on the blog. I may also have positions inconsistent with the views expressed here. Anything posted here by me constitutes my own opinion, and is for informational purposes only.

Relaunch

After a few months of experimentation and trial, The Zikomo Letter (TZL) is re-launching. The focus will be shifting towards longer posts, once or twice a week, discussing various features of trading, investing and personal finance. You will see more of my own thoughts and convictions, argued with more passion and hopefully more humor.