Aurora Borealis
1 January 1981 Financial Analysts Journal Volume 37, Issue 1

What Does It Take to Win the Trading Game?

  1. Jack Treynor

A transactor naturally assumes that his counterpart—the transactor on the other side—is drawn randomly from the population of investors. In fact, the latter transactor is drawn from that much smaller group of investors who have a reason to transact. The latter’s reason for trading represents an element in the former’s trading cost that dwarfs commissions and transfer taxes.

Generally speaking, there are two fundamentally different motives for trading. One is information that the transactor believes will change the outlook for a company, hence the price of its shares. The other is value—a perceived discrepancy between market price and what the transactor thinks the shares are worth.

Concerned with the incremental impact of his information on price, the information-based transactor has little interest in value. On the other hand, because his information becomes worthless when fully discounted, he is always in a hurry. To secure a timely transaction, he will often be willing to pay the price of the value-based transactor on the other side.

Because he sets the price at which the transaction takes place, the value-based transactor can exact a premium for assuming the risk of getting bagged. He is, in effect, determining the spread between the price at which one can sell quickly and the price at which one can buy quickly. The spread will expand until, at equilibrium, the discrepancy between a stock’s price and its value is just sufficient to compensate the value-based transactor for his risk.

Decisions to research are tantamount to judgments that the market spread on a security is not in equilibrium, given the volume of information affecting price. A decision to analyze a company implies that a discrepancy between share price and value will outweigh the cost of getting bagged; a decision to investigate implies that information differentials will outweigh the spread cost incurred in trading on them. Without specifying whether one is contemplating investigation or analysis, it is impossible to say whether a large spread—the usual measure of market efficiency—is attractive or unattractive.

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