Why You Probably Won’t Make Money Trading

In the late 1990’s, a work colleague of mine in the engineering department at GE occupied much of his time trading financial instruments. In particular, he liked trading call options on the technology company 3COM. Although manufacturing engineering was his day job, he apparently thought day trading was more interesting. Understandable. It also seemed he had prescient timing with his trades, growing his $20,000 initial investment to $80,000 in about six months.

Every few days, I would mosey downstairs to his cubicle to talk stocks and to prognosticate on the broader financial markets, both of us pretending to know what we were talking about.¹ After learning more about his augural trading strategy and his specific trades, I surmised he might have made even more money by not trading, and just holding his call options to their expiration. Why? Because the underlying stock was going up, as were most stocks during the internet boom of the late 90’s.² With this upward momentum, he was “winning” almost all of his trades. But he might have confused a vatical ability to decipher complex trading patterns with a simple rising tide of the underlying stock, which was in turn entangled in the euphoric swell of the overall market at the time.

One day he said to me,

“If I can just grow my account to $100,000, I can quit my job and trade stocks full-time.”³

I had to admire his appetite for risk, trading options on full margin.⁴ At this rate, he was only a few shrewd trades from ditching his 9-to-5.⁵ This represented freedom, in his estimation. He was pursuing his passion and I’m all for that. But in doing so, he was consenting to bow before, and be at the mercy of the god of risk. Put more aptly,

“Only when the tide goes out do you discover who’s been swimming naked.”

– Warren Buffet

Apparently, my colleague considered swim trunks optional when trading.⁶ That said, he seemed to acknowledge the risk, and thought it worth it… at least to $100,000. Presumably, at that point, he would suddenly become more risk adverse. This brings up an interesting point:

When you have steady income, you can be (and probably should be) more risk-loving with your investment strategies… and vice versa.

For this reason, entrepreneurs are often conservative with their financial investments, because they accept more risk from their income source (company ownership) compared to a traditional job.

Back to my colleague… I remember thinking his trading strategy might implode, yet I was still rooting for him, because his success meant it might just be possible for the rest of us as well.

Then 3COM turned down. Thinking this was another buying opportunity, he kept buying call options, doubling down, eventually trading his $80,000 down to $30,000 over the next few weeks. He didn’t quit his day job… nor did he get much done at work as I recall. Nevertheless, it was interesting to watch, in the same way poker is more fun when someone else pushes all-in. It’s not the game. It’s the stakes. For an observer, the outcome is less interesting than the stakes. For the principle, the outcome justifies the stakes… or it doesn’t. In this case, it didn’t… and a lesson is learned.

Sometimes, early successes in our endeavors allow us to mistakenly attribute genius to luck. Sometimes the best outcome is an early setback, because we are forced to step back and spend the requisite time learning the hard-won lessons that develop our trade skills and overall business acumen. These skills fortify us to make wiser decisions later, presumably when the stakes are larger.

Investing vs Trading

There’s a significant difference between investing and trading. Investing usually involves a long-term view, evaluates the fundamentals of the underlying investment, makes educated projections about future prospects of the investment and compares these prospects to the alternatives.⁷ Conversely, trading is more short-term in nature and often looks for patterns and signals (sometimes where there are none). To grow your capital, don’t conflate the two. My work colleague was, without doubt, trading.

Almost everyone is better off investing rather than trading.

Inherent Advantages of Financial Institutions – Your Trading Nemesis

When you buy or sell securities, there is a counterparty to the transaction. If you buy, someone is selling and vice-versa. Sometimes your counterpart is not as smart as you and you have an advantage. Sometimes your counterpart is smarter than you. Truth – most of the time your counterpart is smarter than you. This should be the default assumption.

The majority of trading is performed by the largest investment banks and hedge funds who employ highly intelligent traders with unreal mathematical abilities, sophisticated trading algorithms, high-speed networks and equipment to ensure they see more information than you, process that information quicker than you, understand the interconnectedness of variables better than you and trade much faster than you. And, they do all of this in much larger quantities than you.

Your trading counterpart is often the professional, institutional broker-dealer with enormous resources. What might be opaque to you might be transparent to them. Suffice it to say, you have significant trading disadvantages, in access to information, quality of information, computing power, trade velocity and depth of capital.

When two counter-parties are involved in numerous transactions over time, the upper-hand goes to the party with the most information and the greatest strategic advantages (including sufficient capital to ensure they can withstand being on the wrong side of a long series of trades if needed and still remain in the game such that statistically, their inherent trading advantages are realized over time). An individual might have some short-term wins, but the institution will ultimately prevail precisely because the odds are stacked in their favor. Vegas is a good analogy here.

On the battlefield of trading, some people have tanks, some have automatic weapons, and some have pistols. As individual, retail traders (you and I), guess which one we are. Wrong. We’re out there shooting water pistols and lobbing Velcro darts at the tanks, thinking we have a chance.

Longer-term investing, on the other hand, at least somewhat levels the playing field and acts to nullify some of the institutional advantages of speed and near-term information.

There are other informational advantages as well, although not necessarily legal. I’m referring to insider trading.

Inside Information

In the early 2000’s, I worked as an investment banker in London with the now defunct Bear Stearns. My desk was on the 44th floor of the tower building in Canary Wharf. The corner conference room had floor-to-ceiling glass walls. Initially, most people approached the view trepidatiously before getting comfortable enough to stand next to the windows while looking down. But the view over London was spectacular, especially at night. And we were often there at night. Every night, in fact.

The 44th floor housed the Corporate Finance division where we provided merger and acquisition advisory services for our clients, some of the largest companies in Europe. As part of our job function, we were often privy to the inner workings and strategic initiatives of our clients’ companies, in particular, their potential intentions or inclinations to acquire other companies, divest of corporate divisions or raise capital (either debt or equity). This is “inside information”, which simply means we could know of these events (or even work on these deals) before this information became public. This is perfectly legal, (as this was our job much like accountants and lawyers are also privy to this type of information), so long as this knowledge is not used for ill-gotten gain.

As you might imagine, knowing inside information about a company could provide a significant advantage for trading activities. This is precisely why investment bankers who work in the corporate finance division are not allowed to make trades on client companies’ stock, nor are they allowed to discuss this confidential information with others, especially the traders, who sat on the trading floor, just two floors down. Further, if traders learn of insider information (either accidentally or otherwise), the law stipulates they are not allowed to trade on it. Knowledge of inside information is a breach of confidentiality. Trading on that knowledge is criminal.

Of course, some of the traders were friends with people working in the corporate finance department. Friends from their university days. They hung out in the evenings, had beers together and perhaps even shared a flat in some cases. Nothing wrong with that, as long as insider information remained confidential.

To be super clear here, I’m not aware of a specific instance of insider trading at Bear Stearns, but just think about it practically. Wouldn’t it be within the realm of human nature for someone, over a few beers after work, to hint at some material pending event concerning a publicly traded company or perhaps to voice a particular view or to have a “well-thought-out thesis” (wink wink) on how certain stocks might move directionally in the near-term?

Some people just have a propensity to share secrets for the sheer pleasure that must come from demonstrating they know something others do not. There are always people who need to feel empowered by being perceived as “in-the-know”. And, apparently, the best way to be perceived as such is to share what one knows with those who previously did not know.⁸ Given this human condition, wouldn’t it be more surprising if insider information was kept completely confidential all the time, no matter how carefully the rules and laws are constructed?⁹

It’s also simply human nature to want to take advantage of an advantage (even if ill-gotten).

For me, the question isn’t if this happens, but on what scale. If the bankers in charge of LIBOR were found in collusion at the highest levels of banking, which they were, it seems obvious that this also happens pervasively in the other markets, including the equity markets.

The idea here is that, not only do the institutions have larger pockets, better research, more information and faster connections to the market, sometimes, they may also have key information long before you. Superior knowledge, speed and data. You simply cannot expect to compete, actively trading against the large institutions on Wall Street.

A Story of Insider Trading

Years ago, my company (PEI, not Bear Stearns) was contacted by a financial software company to potentially incorporate our M&A research data into their software product to help “an unnamed financial regulatory body”
¹⁰ better identify insider trading. They had built a technology platform to monitor suspicious trading in real-time but needed more data to make seemingly disparate connections between people, to establish a network of professional, personal, social and casual relationships. For them, linking people together in various ways sought to establish a chain-link of networked connections from a client trade to an original information source (information leak).

More data. Better relationship discovery. More difficult to perform illicit insider trading without getting noticed. That was the idea anyway.

During our meeting, they relayed to me an interesting story of insider trading their system had detected during the testing phase. They were quite proud of the uncovered result. This is their story…

The Suspicious Trade

A suspicious trade was made in the options market on a particular stock. Someone purchased a block of call options just prior to a big company announcement that pushed the underlying company’s stock considerably higher. Great timing! Someone, having never previously traded this particular stock, acquired a substantial call option position on this company. Apparently, this trade really paid off. Red flag. The timing was just too divine for the “unnamed institution” and triggered further investigation.

Starting with the owner of the brokerage account who made the surreptitious trade, they were able to unravel the following:

• The account was established in the account holder’s maiden name.
• Through public records, the software tied the account holder to her husband, an attorney.
• Although the husband himself was not involved in corporate securities law, his colleague at the same law firm worked on the deal team that caused this newsworthy event for the publicly traded company.

By combing through and combining previously disparate data sets, the software’s algorithms were able to unwind the connections and discover these relationships within a few seconds. The relationships were a little too coincidental. To the “unnamed institution”, this relationship network was sufficient to prove insider information had been shared… and acted upon. And that’s the key point, that it was acted upon.

This is an example of insider trading, on a relatively small scale. A rare case of someone getting busted. But it’s also an example of how information gets shared and how the counterparty to your trade might be considerably more informed than you… at least on a short-term horizon… even if they are not a large institution.

For the rest of us, it’s safe to assume we are nearly-the-last-to-know key information that might affect a company’s stock price.

Conclusion

Most individuals should not trade. We are much better off investing. Invest in great companies for long durations. Better yet, buy and hold an index¹¹ … for decades.

FOOTNOTES:

1. In the stock market mania of the late 1990’s, nearly everyone had a view on the financial markets. Most thought it was going up… steeply… forever. We were young and had yet to see a downturn, much like the young people investing in the market today.
2. It was difficult to go wrong buying stocks during this period, although this didn’t stop me from losing money on some bad trades myself.
3. Considering every time I saw him at his desk, he was looking at stock charts, one might wonder if he had already quit his day job mentally.
4. “Margin” – borrowed money from his broker, leveraging his capital 2-to-1. This effectively doubled his buying (or selling) power. Double the upside. Double the downside. Double the risk. Double the fun.
5. “What a way to make a living”, sing it…
6. This reminds me of a completely unrelated story. Two summers ago, we went to the Blue Lagoon just outside Reykjavik (Iceland) on our way home from Sweden. The Blue Lagoon is a beautiful pool heated by Iceland’s natural volcanic activity. Before joining the pool, you are supposed to shower, which we did. Soren and I went to the boy’s showers while the girls went to the girl’s locker room. After Soren and I showered, along with the other guests about to enter the pool, we started to walk toward the exterior door to the general pool area. Fortunately, as we approached the door, Soren said, “Wait. Daddy. Aren’t we going to put on our swimsuits?” Oh yeah. Forgot that part. This is when you know you are either too pre-occupied with your own thoughts or you have been in Scandinavia too long.
7. Investing also considers the best alternative may be to do nothing and simply hold a position, even if that position is in cash.
8. 
   Of course, people who demonstrate they are in-the-know often don’t stay that way for long, because the rest of us quickly learn not to tell them things. We are generally suspicious of anyone who tells us a secret, even if we don’t explicitly say it aloud. Our intuition informs us of this naturally.
9. Frankly, most people can’t even keep a secret within the small circle of their own friends and family, so it stands to reason that secrets get shared beyond the confines of their original intent.
10. The people I met with went out of their way to say the “un-named regulatory body” was “definitely not the SEC”. Although they did not actually wink nor use air-quotes when they said this, I understood this to mean, it was definitely the SEC, implied through the cadence of speech, “definitely NOT… the SEC”.
11. Except maybe not right now.