The other day a reader left a comment on one of my columns, lamenting that I did not hold out much hope for small traders and investors. I didn’t mean to create that impression at all. There’s a lot of hope for small traders and investors — providing they are willing to do the work.
My intent was to paint a picture of what the markets are like today and outline what not to do as an investor. To find success in the market, you can’t do what everyone else is doing. You have to think differently and learn to profit by doing the opposite of what the large pools of money that dominate financial markets are doing.
Let’s look at stock trading. The little bit that I do is arbitrage-related selling of options (with a value flavor) and using puts to create short positions on overvalued stocks. If I were to engage in short-term trading, the first thing I would do is take a refresher course in higher math with an emphasis on statistics and probability, or hire a math whiz. The vast majority of successful traders I know rely heavily on this type of market analysis.
Given the enormous amount of money being channeled into exchange-traded funds and other index products, I would focus on building models devoted to the mean reversion of index components and dispersion trading. A large amount of money flowing into these products regardless of component valuation has to create mean reversions of the components that can be exploited by traders. Adjusting for index weightings and other factors is a daunting task. But if it was easy, everyone would be doing it. Trading success does not come from an off-the-shelf product. It takes original thought and lots of hard work.
If index-valuation components occasionally get out of line and forced back to the mean by money flows, options on the underlying components would be subject to the same pricing mechanisms. If I were interested in shorter-term trading, I would have option-dispersion models to spot the volatility and pricing anomalies in an attempt to benefit from the eventual correction and re-pricing. Again, if it was easy, we’d all be rich.
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