January 12, 2010

Trading 101

Thought for the day: “Chaotic action is preferable to orderly inaction.” – Will Rogers

Speaking of chaotic action, let’s review trading basics. We tend to think trading is buying and selling stock. To quote John Kerry, would that it were! Most trading today isn’t done for capital appreciation but to capture short-term divergence or to balance risk.

We’ll start with the big picture. The broad market-structure profile thus far in January isn’t too different from the same period in December, except volumes are up about 20%. The increase is mostly electronic market-making – think of it like transaction processors who don’t own things but simply facilitate commerce for a fee. By our measure, that’s about 36% of trading.

Who’s doing business with them? For one, speculators. These participants, which range from the largest bulge-bracket desks to the smallest introducing brokers, have driven about 33% of volume in January. Notice that it’s similar in size to the EMM segment.

Risk-management program-trading is another roughly 21%. This activity rebalances index vehicles, mutual funds, asset-allocation models, counterparty obligations and so on. The remaining 10% is active investment. There’s some crossover of course, because algorithms run close to 98% of volume today and barely any trades are old-fashioned manual entry.

Keep in mind that investors pursuing value and growth don’t trade every day. They tend to do thing in lumps and globs. Still, owning things for sustained periods is risky business now. Instead, securities are in constant motion. This is why speculative and market-making volumes are so high. Inexpensive, high-speed execution is ubiquitous because there is constant, chaotic motion of shares, driven by complex mathematical systems.

Even active money moves this way. What an investor thought yesterday about the value of a given stock may be different today. Perhaps program trading changed, causing sales traders and execution specialists to take offensive or defensive postures. There’s no stasis in the markets, unless it’s what regulators illogically and weirdly hope to achieve with “systemic risk.”

Ironically, these conditions mean market structure is easier to understand than you might think. Math is logical. Even Chaos Theory is a mathematical proposition. Things move from a state of order to a state of disorder. Molecules move apart over time to fill available space.

This matters, IROs, mostly because it’s reality. We can deny reality and continue to do the same old thing. Or we can be proactive and redefine our job and its measures.

Resolve that Twenty Ten is the year you’ll get to know your market structure and introduce your management team to your stock’s Market Structure Profile.

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