My favourite regular contributors to Daily Speculations include Jim Sogi and, of course, Victor Niederhoffer. In response to a piece by Sogi titled ’1001 Ways to Lose Money’ (Dec 28), Victor Niederhoffer made a few comments that got me thinking:
On market design
“Never be overconfident. You can sink in a moment on a boat, and lose everything with one bad trade in the market. Try not to be overly pessimistic either though, as the market is very resilient, and the infrastructure is designed so that the system can continue and capital can be raised and entrepreneurs will reap returns for their creativity.”
I believe it pays to appreciate the purpose of marketplaces and the differences between them. The central and original function of the equity market, for example, is to act as a meeting place for capital providers and entrepreneurs seeking to finance their ideas. Despite the pervasive bearishness in the media, this vital role helps to explain the upward drift we observe in the market. If capital providers failed to achieve reasonable returns over the long-term, the system would likely starve itself of capital as investors directed funds to more profitable activities. The positive drift tells us that all is well, and that we should not be overly pessimistic.
The foreign exchange market however, is a very different beast. There is less transparency (eg: no central clearing of currency prices or information on volumes), and the fx market does not appear to serve as noble a purpose as the equity market in financing creativity and driving economic growth. Exchange rates are vital to international trade and are important to a fully functioning free-market economy, but it seems many countries are content to live without freely floating rates. Also, despite all the talk of foreign exchange as an asset class, I still do not really perceive any real assets as being traded – in my view fx rates are simply the relative prices between two countries (with a carry component). Indeed, whereas the equity market can reward all ‘long’ investors over time (it is not a zero-sum game), in the currency market a trader cannot be long one currency without being short another. So, even before frictional transactional costs, currency trading is a zero-sum game. The point of this ramble is that if we look at the foreign exchange market place, the structure and purpose of the market is such that, on average, participants should expect to lose more often than equity investors who tend to trade from the long side. The very nature and structure of the currency market helps to explain the general absence of drift, and warns us of undue optimism.
On grinding and the ‘stress frontier’
“ … remember that the only one that can really grind is the house.”
No doubt some traders employing grinding approaches will make a living , but the tendency surely has to be for the majority of short-term trader’s to get ground down to dust as transactional costs eat away at their equity. In the equity market, investors generally pay a spread, a brokerage charge and sometimes a tax. In the spot forex world, the trader is faced with a spread that is extremely low as percentage of the exposure, but this charge is present and it has to be acknowledged. If a trader is to be profitable, their edge has to to beat both the randomness of the market and the charge. In currency trading, macro traders would appear to have a clear advantage because if they are looking for moves of several hundred pips on trade, a spread of 1-3 pips (major currency pairs) usually brings the transactional costs to a fraction of a percent. In contrast, when a short-term trader is looking for a swing of 20-40 pips, the spread can often exceed 10%, making life exceedingly difficult. But still we keep trying.
I find a parallel with nature: in ecological systems, species often operate on what I call a ‘stress frontier’, where population sizes grow to a point at which predators, natural habits, prey etc become significant pressing factors. Most species seem to operate on this ‘stress frontier’, struggling but managing to find food and defend against enemies. Quite often, this ensures a certain dynamic stability in the wider system. When it comes to trading, as transactional costs have fallen in nominal terms over the past decade, my impression is that more traders have been attracted to the system and that traders have tended to focus on ever shorter time horizons (I am one of them); reading blogs of others currency and equity traders, transactional costs still seem to average between 1-5% for many trades. Perhaps it is in our nature to make life a little difficult for ourselves. This could be tested by looking at the historical percentages of profitable traders to losers, which I estimate would be largely unchanged over the years despite the significant reduction in trading costs.