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I revise this about once a year, adding a few sentences or a paragraph or
two here and there based upon my recent observations, and send it out.
It's time again.
TRADE SECRETS
No one in the market is knowingly giving away money. Like an ordinary
poker game, trading is a zero-sum business, and it's your job to take my
money and mine to take yours. "Us against the market" theory died in the
60's, if it ever had a life at all. And if you imagine that you can pay
someone $3000 and acquire a business that nets you $1000 a day, you are
just being silly. This is an information game and information is the coin
of this realm. If you have some valuable information that might help me,
I'll trade you for some information of similar value. Like it or not, that
is the exchange mechanism in this marketplace of ideas.
As a contrived but apposite example, suppose you have developed an
extremely high probability recurring S&P buy condition which leads almost
always to a quick $3 increase in the S&P, and you let the world know about
it. When thousands of bids to buy in size suddenly hit the S&P pit, do you
really think any of them are going to get filled anywhere near the current
price? Even if the market had enough depth to absorb them all, what floor
trader would choose to sell? You can easily translate to the case of an
extremely informative measurement, indicator, or pattern, or chart.
In fact, what happens when such knowledge becomes widespread is very
similar to what happens in a takeover situation: the market estimates the
proximity of its current state to the condition which would cause the price
increase, and price then rises with p, the probability of reaching that
condition . The jump in price becomes a gradual rise as awareness of the
condition increases, and the profit declines more or less proportionately
with 1-p. And the opportunity simply disappears. I remember a New Yorker
cartoon, in which two fishermen were sitting in their little commercial
fishing trawler, and one said, "If you give a man a fish, you feed him for
a day, but to teach him to fish is just plain stupid."
The S&P and several other markets that I trade are steadily degrading,
which is to say becoming more efficient. I have made measurements that
demonstrate this clearly to me. I understand from Linda Raschke that Perry
Kaufman has also noticed a similar effect more generally in measurements he
has made in a variety of markets. The markets always evolve; how quickly
they change is a function of the information disseminated and of their depth.
Market opportunities ultimately and inevitably disappear, evaporating
naturally through the very process by which traders exploit them. Even
non-traders have witnessed this phenomenon vividly in the California gold
rush market of the 1840's and 1850's: after the easy surface gold was taken
out, only the well-financed could profitably search for gold. Today you
need a high tech operation that would boggle your mind -- and your bank
account too, however large -- to make a profit mining gold in California,
and the return per unit investment is minuscule compared to the return
experienced by the original miners. That is what happens to a market after
it (as they say) "matures".
An inefficiency in a thin market is not of much interest to traders,
because modest exploitation will remove the inefficiency. Of real interest
are the deep inefficiencies: those in high volume markets. The largest
hedge funds trade currencies because those are the only markets deep enough
to absorb their transactions without extreme price slippage. How deep are
the inefficiencies in the various markets?
Certainly the inefficiencies in shorter term markets are not as deep as
those in the longer term markets -- the gold in shorter term markets is
closer to the surface and will be extracted more quickly, and short-term
trading opportunities will disappear first. And certainly the derivative
markets are deeper than their volume alone would suggest, because
value-discovering activity in them is absorbed also by the volume of their
underlyings, a lot of which is quite naive and slow to act and react.
But the easy availability and increasing power of analysis platforms on
personal computers, together with the efficient dissemination of
information and data through the various media, makes it now easier than
ever to learn relationships that were previously known only to a few, and
you can be certain that in 10 years, and perhaps in even as little as 5
years, you will no longer be able to accomplish with your wits what you can
accomplish today.
A good illustration is the now highly-evolved market in options. At the
beginning of the options markets in the 1970's, you could bootstrap
yourself up with few resources but your own ingenuity. One could, for
instance, regularly find delta-neutral/low-gamma spread positions that not
only covered commissions but also gave a handsome and high probability
profit. You could even occasionally buy long butterfly spreads for a
credit, making your profit 100% certain. However today the potential
returns even from market-neutral hedging have diminished to the point
where, to profit reasonably from a deep understanding of options, you have
to go to work for a firm with a floor operation or a firm like Salomon
Brothers. And even for such firms the profit is no longer nearly as
reasonable as it was twenty years ago.
If you possess extraordinary market information, I would counsel you not
to give it away, but to use it in the market yourself if you can, or at
least trade it for other extraordinary information that you happen to need,
or if you don't want to trade it then at least to get paid extraordinarily
for it. And if you really have to give it away, by all means don't give it
to a group of anonymous strangers on a list -- give it to someone in your
family. Or to a friend. Or me (:}).
You may naively imagine that your generosity will be returned if you
graciously put your information out there for the group to see. But that
will not happen. There are in fact lurkers on every list who never
contribute anything, but merely take what is valuable for their own use.
Put a truly valuable piece of market information on a public list and I
guarantee that you will not only not ever hear from the grateful
beneficiaries again, you won't even hear from them in the first place --
they won't as much as thank you, they will simply disappear with your
information and use it, and you'll never even know who they are. You'll
just notice one day that the market no longer offers you the same
opportunity it once did.
Even newbies can have interesting insights. When I first started looking
at market data in 1971 and was trying to understand price behavior, one of
the first graphs I created was a market profile graph using volume. The
graphs were too cumbersome to mass produce by hand and I finally wrote a
program to display them around 1977, but even then the data were not
available to me in an easily accessible way and I was not able to explore
the tool properly, so I resolved simply to explore this tool, which I
considered then to be the key to the atomic structure of the market,
exhaustively "someday". When in 1987 I saw a picture of "my graph" in a
magazine, I was quite chagrined, although in retrospect it was unrealistic
of me to think that this way of looking at the data would forever remain
unknown.
How can you know if a piece of information is valuable and novel? If you
have read the literature, and know the contents of the various books and
publications and mailing lists, you will know if your idea is novel. If it
is widely known, it's value is of necessity limited. If you have a
technique that is unlike any other you have ever seen, and you wish to
explore it and do not have the resources yourself, you should probably
search out a trader or two who can help, rather than put it on a list and
expose it, ultimately, to the entire investment and trading world. Or ask
a few questions that will lead you to the information you need without
disclosing the entire enchilada. Or simply keep it in your desk until you
have the necessary resources.
At one time, I purchased a number of foreclosure properties. When a
property on a distant lane in a suburb goes to foreclosure, you will
occasionally have trouble locating the property for inspection, as the
house numbers on the house, and sometimes even on the neighboring houses,
will have been removed by someone who hopes to keep the information about
the property to himself. Sometimes even the street sign is gone. In other
cases, the sale will be held at a time and location that may even make it
extremely difficult, or even dangerous, to attend. Once I was the only
bidder on a building located on a little street which was for some reason
not even shown on the local Thomas Brothers map, the standard guide used by
the real estate community. I knew where the street was because I once
owned a property on that street, but no other bidder had even been able
even to find the street, let alone see the property. In the midst of a
crowd of heavy-hitting bidders who looked on without understanding at all
what I was up to, I purchased the property for $200,000 below its market
value right from under their noses, because I was the only one who had been
able to find and inspect and evaluate the property. Trading is like buying
foreclosures -- you get the best deals when no on else knows about them.
And then there are the academics. Academics, of course, get paid not for
taking trading risks but for writing papers. Little information is safe
with people whose career ambition is to publish the next Black Scholes
equation. In case you didn't know, the Black Scholes model had been
derived and was employed by a number of practitioners for several years
before it was published. It's publication contributed immensely to the
disappearance of both deterministic and probabilistic delta-neutral
arbitrage opportunities in the options markets. It should be noted that
this process then took almost fifteen years. Were such a tool to be
revealed today, today's communications efficiencies would vastly accelerate
the process and those opportunities would disappear much more quickly.
It goes further. The first step in doing anything extraordinary is to
believe it is possible. Before Roger Bannister ran the mile in three
minutes and fifty nine seconds, it was thought that the four-minute barrier
was insurmountable, a sort of theoretical human physical constant, and that
intrinsic limitations in the structure of the human body made it impossible
for humans ever to run a mile in less than four minutes. And in all of
history no one did it -- until Bannister. However as soon as Bannister
broke that barrier, his own 3-minute and 59-second record was broken in
quick succession in a matter of weeks by many others: the four-minute
barrier was not in the runners' bodies, but rather in their minds.
Similarly, Jack Schwager's Market Wizard interviews demonstrated to many
people that consistently successful trading was possible. Although
Schwager's subjects dealt with earlier and easier -- which is to say, less
competitive and more inefficient -- markets, and although certain of the
more extreme performances could no longer be replicated, the mere fact that
such performances had been achieved led many to develop market skills who
previously had accepted the prevailing academic view that the markets were
efficient and consistently successful trading was not possible.
Schwager's interviews contributed in their own small way to the growing
efficiency of the markets and the disappearance of trading opportunities.
Thus, in view of the four-minute mile syndrome, not only is it unwise to
disclose trading technologies, but it behooves the extremely successful
trader not even to publicize his or her results, as such publication will
only stimulate investigation and competition and cause those results to
degrade in the future.
Bob Brickey put it very succinctly when he said, "Traders make money by
taking it from each other. Those with superior knowledge are able to take
money from the majority with less knowledge. Superior knowledge shared
with the majority ceases to be superior knowledge. It's value in trading
therefore is gone".
How is trading knowledge disseminated? I doubt that George Soros lurks on
Internet mailing lists, but probably some of Soros' employees do, and
certainly some smaller CTA's read them, so you definitely have sizeable
money looking on there. Exchange floor traders of course are
well-represented on Internet mailing lists and many read everything they
can about the markets. The floors are very social places where any
entering information quickly becomes common knowledge. And of course there
are academics busily reading market materials and trying to figure out how
to use them to their benefit, the university job market being what it is.
It is safe to assume that any valuable information published or posted for
public view will be quickly explored and absorbed rapidly into the
marketplace, perhaps even by large CTA's, which is to say very quickly even
in cases of information that relates to longer term trading. These
institutions employ people to develop good trading ideas and don't have to
give their employees anything but a salary and a job and some incentive
pay. And for that, the employees read everything.
Enough said. I have to assume that, for those out there able to develop
original insights into market behavior, this is by now all self-evident.
This is not meant to discourage the exchange of ideas -- even in a
cut-throat poker game, players develop alliances -- and it is surely not
meant to discourage the free exchange of technical or hardware or
operational information. I've certainly gained immeasurably from all of
those, and I've always gladly learned something from traders more
experienced than I, and I hope to continue to do so in the future. And
it may even make sense on occasion to publish some important market insight
for the feedback it generates. Just be prudent about it.
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