Book Review: The Laws of Trading
astralcodexten.substack.com
astralcodexten.substack.com
> In as technical a field as trading, sheer willpower is often what gets things done in the end.
Institutional and retail trading are as different as Microsoft and a solo startup side project.
Some principles transfer, like gambling theory, expected value, risk of ruin.
But retail trading tends to be more like the person who just really loves Excel, and they’ve somehow built an inefficient monstrosity of linked Excel files that only they understand, to accomplish what should be handled by an enterprise ERP. But it works. And it turns out you can make a living this way.
Institutional trading is no doubt one of the hardest games one can engage in.
But retail trading: They’ve figured out how to plow a field with a spoon. Either because they are obsessive about fields, or spoons, and it just happens to be the case that one can make a living plowing fields.
A retail investor may only need a small, fertile, family farm. An institutional investor isn't even looking at something under 100 acres.
I don't really know, not my field.
Have they, though? Or, perhaps a better question, who is "they" and how do they make a living retail trading?
Aren't most successful retail traders successful by being on the correct (lucky) leg of the random walk?
I have been under the impression that the ratio of successful to busted retail traders is quite close to zero.
Ironically my best investing decision ever came about due to a drinking session in a KTV in Beijing. My assigned Chinese "companion" was flaunting her new iPhone 4, so, curious, I asked her in my rather limited Chinese: "Are these iPhones popular here". She responded, eyes glowing, "是！我们都有！” ["Yep, we all have them"]. Readers can guess the rest of the story.
In China, despite Foxconn assembling Apple products there, the first Apple Store only opened in 2008 and its products rarely seen anywhere before 2009. The commonplace assumption across the financial press was that China was too poor, and its consumers too practical, to pay a needless premium for iPhones. When I heard in early 2011 from the KTV hostess that iPhone 4 sets were universally popular among her colleagues I realized that iPhone mania in China among trend-setting urban women was underway and that the narrative was badly in error. And I believed what was subsequently borne out that this trend would rapidly spread all across China over the next decade.
Of course, much other subsequent real-time "research" went into my investments, during life and travels across Asia, and I developed a variety of ways to hedge my positions. But what set me apart as an outside amateur was that I had deep, real-life knowledge of important foreign markets that the Wall Street financial press and institutions either ignored or got wrong,
If there were YouTube ads for weekend boot camps to become a doctor in 3 days and start making 6-figures next week, we’d ask why 99% of doctors fail.
Aside from luck, many appear profitable for a while, maybe 1-2 years, but even most of those have tricked themselves. They use too much leverage and beat the market until an infrequent correction happens and wipes them out, or they follow scammy systems that have high win rates and a very long duration before they hit a drawdown that wiped out all prior profits. Picking up pennies in front of a steam roller.
For instance, you can pick whatever win rate you’d like, but it won’t necessarily be profitable. The scammer selling the course understands how that works, but the newly certified trader doesn’t.
Determining who “they” are is honestly hard, because luck and leverage can pave a long runway. If someone starts a business, and exits 5 years later with 7-figures in the bank, is there a way to know if they’re successful at business or just lucky? It’s hard to answer that question, good business people still exist.
Some fundamental understanding of the asset class and market microstructures is needed (if not on the tech side then the quant side, but ideally both) so you know what you're trading. Given the sheer volume that goes through your typical broker-dealer, that's quite a reasonable investment to make.
I try to explain to retail investors and outsiders interested in markets that this whole operation requires a truly mind-boggling amounts of money and brainpower to keep going on a regular basis, but it's hard talking to people who have never experienced working in the industry.
MMs aren't doing deep analysis like a hedge fund, but they do have insight into the buy/sell interest across the market.
And how do you think one makes a market if they don't have an idea what something is worth? Prices aren't necessarily values, MMs value instruments and then trade accordingly at prices quoted. They don't search for misvalued items like a l/s fund, but they always have a theoretical value and make a market around that internal number when asked.
Hmm, would "A Random Walk Down Wall Street" [0] qualify as another exception? It's been a while, but I seem to recall it as neither a "I'm genius invest with me" nor "let's point and laugh at those guys".
[0] https://en.wikipedia.org/wiki/A_Random_Walk_Down_Wall_Street
It's important to understand - on the whole - he average probability of guessing the direction of a trade is 50/50. Any obvious (and virtually all non-obvious) edges, arbitrage for instance, are removed by the market participants. That's what a market IS.
In that respect, 'random walk' is correct. However, that does not mean all participants cannot expect profitability over the short or long term. Which are also themselves, very different things.
For retail traders, transaction cost (commissions + bid/ask spread) make it a negative expectancy.
In fact, bid/ask spreads and commissions ARE PRICED right at a level to remove any positive expectancy, but leave the APPEARANCE of a possible positive one.
Getting that up just a couple percentage points to a positive expectancy is difficult in the short term, and VERY difficult over the long term. Not impossible. That's why about 70-80% of active retail traders are losing overall at any given time.
For firms, order flow and much lower transaction costs make for a positive expectancy. The value of order flow alone is responsible for the zero-commission trading industry.
Skill isn't the issue. The trader with skill level at lose a little or break even trading - from his bedroom - would very possibly be winning on the big banks trading desk. Even if executing the SAME trades they were at retail. More so, the more frequent the trading activity.
So if big institutions have a built in edge why do they sometimes fail? Easy, they still sometimes make stupid bets (ie.. Silicon Valley Bank's bond bet which killed it).
I think most of what you have written is basically false, at least for US equity markets.
The reason institutions like trading with retail (for equities in the US) is not that they get to charge big commissions. It’s that they don’t have to pay for the high risk of adverse selection. I.e. trades with retail tend to not be regretted because the market is not particularly likely to quickly move in the direction that favours the retail trader.
If you are retail and you have some actual edge, you could find the brokerage which gives the tightest spreads (mostly this means the one with the worst traders except some take much more pfof). But there are likely better ways to get leverage than trading on your own account, eg selling a newsletter or working for a trading firm where you have more capital.
Investing in a market spread (eg an index tracker) over the long term with infrequent trading during that time is a different strategy that trusts the market rather than the individual's "skill".
This latter is presumably what your relative was (correctly) advising.
Another thing, it takes a while for news to price in. If inflation craters and it means the QQQs should be 10% higher, that move CANNOT happen in one day.
Enjoyed the analysis, thanks for sharing.