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How to avoid becoming bait for professional traders

How to avoid becoming bait for professional traders

By Investopedia.com 13.01.2012


What is the difference between investing and trading? Whole volumes have been written on the subtleties. Although some educators teach that trading is a type of investing, we need to make a different distinction today.

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Investing, for purposes of illustration, is the practice of allocating funds in a buy-and-hold market move, generally with a market order, where small differences in price are inconsequential to the portfolio objective, which is seen as long term. Trading is about the mechanics of bringing a buyer and seller together and making money during and because of the transaction itself. By definition, executing a stock trade is an "instant-in-time" sort of transaction, whereas investing time horizons can be years.

The small differences in price, which are inconsequential to the investor, are at the heart of trading (in addition to a transaction fee volume if you are a professional). If we buy a security one day for $30 and sell it a week later for $31 or $29, the dollar difference is small compared to buying Microsoft at $21 during the company initial public offering (IPO) in 1986 and holding it until 2001 when it was equivalent to $10,000. Even less significant, are the minute-by-minute "streaming quote" differences of a "tick."

However, if you make trillions of trades and profit a little on every one, these small differences add up. The "market's inefficiencies" are based on an unspoken agreement between investors and traders because of this difference in where profit comes from. In the outlook of an investor, profits don't come from a zillion pennies. For a trader, taking a risk over decades is more dangerous than trying to profit no matter which way the market is heading.

"Traders set the price, investors get the price," is another important way to distinguish the two activities; however, there is trouble on the horizon. The "gentleman's agreement" where the "average investor" makes a market order purchase to buy and hold, breaks down when the average investor decides she or he wants to make a short-swing profit. Suddenly, the differences in objectives make an "uneasy truce" between the two sides' outright competition. The side with a thousand shrewd traders, with banks of computers calculating spreads and setting the price, is most likely to win.

There is a sad recent phenomenon not always spoken about candidly, or sometimes even joked about by professionals: the "amateur trader" has become a significant new profit opportunity for professional traders. If we trade often, we're incurring significant transaction costs and playing a game we can't win, if we remain unconcerned or unaware of which side of the bid/ask spread we're "harmonising" with, or who is on the other side of the trade. In other words, we can't be a price-taker and ever profit from trading, especially playing against large institutional traders who can't lose, because they can set the price.

In economics, there is a technical term called a "price-taker." This means that you can make a buying or selling decision and your output is assumed not to affect the price. (Actually, MR=delta TR/delta q =(p*delta Q)/delta q=p, or MR is inelastic with respect to output so the price graph is horizontal, but we don't need to go into all of that). In practical terms, if someone has a monopoly, their own actions can set the price they charge, because, if you control supply, demand has to take the price you charge.

Pretend you're doing the opposite: you decide to sell water. You are selling a product that is available from a zillion other places and for which consumers can see prices everywhere, from their water bill to the supermarket. If you decide to set the price of a gallon of your water at $10, you will likely sell zero, because as a commodity, even differentiated water from icebergs might sell for $1.20 instead of 95 cents a gallon in a health food store. The feeling that you can't really set your own price or control your own margins is what a price-taker feels like to an individual in an efficient market, or to a company with very small market share amongst a pack of other suppliers.

So, how can traders dictate prices and you become a price-taker, when markets are supposed to be efficient? Shouldn't they be takers too? Technically, yes, but there is another side to the trade when it happens at an instant in time: for every trader who wants to "buy low/sell high," there has to be another trader with disparate information on the other side of the trade, who the first trader thinks is "buying high" (by definition). The second trader thinks they're also "buy low/sell high" but both cannot be right at the moment of the trade. If the second trader turns around and tries to sell quickly, they're facing into no-win odds, because they are bringing the wrong tools to the game.

These discrepancies happen because markets and information are not always efficient. Professional traders have access to information and use techniques not well understood by average investors. The most important example on this topic is the trade objective/type interface. When you sign in to your online broker and the little pull-down menu lets you select market or limit order, the average investor, time and again, chooses market. That means, "hey, I want this stock, go grab it for me at as close to what its trading at right now."

The investor is focused on that particular stock and isn't as concerned with technicalities like limit orders. The objective is to buy that stock because it is hot, loved, underpriced, based on a tip, etc.; we are target-fixated on the stock and don't care as much about small differences in price, as getting it right away while it is low or before it goes up. Frantic novice day traders think that's how day trading works, but this couldn't be farther from the truth.

A shrewd trader is more likely to take their time, carefully set a price trap and wait for the wildebeest-novice to step in it. Shrewd traders do not want to be price-takers, they want to set the price, so they always use some form of limit order. Never, ever (ever) buy at market for a short swing; market orders are (by definition) putting a little red "kick me" sticker on your back that says I'm a price-taker. It's OK to be a price-taker in an efficient market where our objective is long-term growth, but not in a time horizon where profit comes from setting prices and capitalising on market inefficiencies.

Professional traders play with a loaded deck. They make money whether the market goes up or down, on pure transaction volume and their ability to set prices. Understanding limit orders is the first step to success. Like any shrewd buyer, you are saying, "hey, here's my price: take it or leave it" and you are willing to walk away over that price. If you do this and are sitting waiting with a block of other "pros" you are playing their game. To do this, we have to be absolutely detached from wanting a particular stock at any price.


 



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