Friday, July 19, 2013

Book Review: Trading and Exchanges

A friend lent me Trading and Exchanges by Larry Harris over the summer. I found it to be a fantastic read. It pretty much classifies any type of trader out there, explaining what reason they're in the market and how they accomplish their objective.

I'll try to give a summary of the main types of traders mentioned and possibly an analogy for them.

Utilitarian traders are traders who have some intrinsic interest in a good. For example, chicken farmers are natural buyers of corn, and corn farmers are natural sellers. In the stock market, companies and retirees are natural sellers of stock and investors are natural buyers. They're the reason markets exist: to have those who value goods the least to sell it to those who value the goods the most.

Gamblers are a type of utilitarian trader who trade for entertainment. They tend to lose money.

Value traders are traders who somehow estimate the future value of a good. For example, stock analysts look at earnings projections and news reports and try to infer where stock prices are headed. Here's an example of how a value trader might provide value. Say there is a town with a huge water supply. Water is cheap so people use it inefficiently, for example in water gun fights, leaving the tap on, fountains, etc. A scientist predicts a drought so he builds a huge reservoir, fills it with water, and later sells it for a high price during a drought. People will criticize him as price gouging and launch expletives at him, but he actually did something socially useful, which is that he prevented the consumption of water by the town that valued it lowly, but instead sold it to the town in the future that valued it highly.

Frontrunners are traders who figure out/guess that somebody else wants to buy something. Legally, frontrunning occurs when a broker trades ahead of his client's order, which is illegal. Other forms of anticipation are completely legal. In any case they're not socially beneficial. Let's say you're at the store, and you want to buy the last carton of eggs in the store. Somebody knows you really need the eggs, so he runs in front of you (hence the term), buys the eggs, and sells it to you at a higher price. Kind of a dick move.

Technical analysts are traders who try to front-run uninformed investors, especially gamblers. At the same time, technical analysis is mostly BS so they're essentially gamblers themselves. They don't provide social value, except in the money that they lose on average.

Bluffers are traders who spread misinformation in the news or online and back it up with huge purchases or sales that make the news seem feasible. They essentially manufacture bubbles or crashes. A great recent example is possibly the hacker who used the AP twitter account to say that a bomb had exploded in the White House.

Some Syrians claimed credit for this. If they did it, it's quite likely that they made trades to profit from the panic.
It's not socially beneficial, obviously.

Liquidity providers: Liquidity is roughly "the ability to buy or sell goods near the market price in a timely manner", or very short-term supply and demand elasticity. You can read more in the link.

Market makers/dealers are traders who post bids and offers. They make money off of the spread. That is, they might offer to buy a stock at $49 and sell for $51. An obvious example is a gold or silver coin shop. A large part of their job is to try to protect themselves from adverse selection by value traders, since if they trade with value traders and are unable to rebalance their inventory before prices move, they lose money. If they're good enough at knowing a value trader's intentions, they might even frontrun them. They provide social value by moving goods through time. Without market makers, buyers will often have to wait a long and uncertain amount of time before finding sellers, and vice versa. Therefore, market makers provide liquidity.

Arbitrageurs are traders who "try to buy/sell similar things at two different prices at the same time".
For example, let's say that gold costs around 1000 an ounce in New York and 1001 an ounce in India.
An arbitrageur will sell gold in India and buy the same amount in New York. After the gap closes, he has made a profit of about $1 per ounce. He forces the gap closed by repeating this action. If the gap doesn't close he will have to physically move the gold from New York to India.
Truck drivers are essentially arbitrageurs, because they drive goods from a place where it is less valued to a place where it is more valued.
Arbitrageurs are socially useful because they combine liquidity across different markets. More exotic types of arbitrage exist. Quants on Wall Street buy and sell bundles of stocks that are in some sense similar to each other in order to make small profits.

There are a few other trader types but they're not as interesting for the average trader/investor.

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