We often hear that stock prices rise because there are more buyers than sellers. Critics like to mock this way of thinking by saying that in every trade, there is a buyer and a seller, so there can never be more buyers than sellers. I think this is just being argumentative. At a given moment there can be more traders interested in buying a stock than selling that stock. This causes the price to rise so that more traders are enticed to sell and some potential traders are discouraged from buying. This continues until buying and selling interest gets back into balance. So, we can give the full long-winded explanation, or we can just say “buyers outnumbered sellers.” I can understand if some people don’t like the short form, but that doesn’t make the people who use it wrong. Critics can accuse them of being unclear, but calling them wrong is just being argumentative. If we want to be even more precise, we shouldn’t be counting just buyers and sellers, but weighting them by the ...

Imagine you’re in a grocery store looking at apples. You like the look of them, note the price, and decide to grab 5 apples. But something strange happens. Right after you pick up the first apple, the price goes up. You get the first apple for the original price but have to pay more for the other 4. This is an analogy for the complaints against High-Frequency Traders (HFTs). In stock market trading there has always been an advantage for those who can react fastest to new information. It may seem that the criticisms of HFTs by Michael Lewis and others is just the usual moaning by losers about their inability to compete with winners. But there is more to it than this. Let’s get back to the grocery store and the apples. Remembering your first experience with the price of apples rising while you picked them up, you decide to just watch the price. You stand there for a long time and the price doesn’t move. The next day you watch the price of apples for a long time and again i...

You wouldn’t think that a book about high-frequency stock trading could be a compelling read, but Michael Lewis’s story-telling skills make his book Flash Boys a page-turner even for readers with a modest knowledge of stock trading. I’ve read several articles explaining high-frequency trading (HFT), but Lewis weaves much clearer explanations in with the stories of the people who set out to stop high-frequency traders from exploiting the rest of us. The book describes many ways that high-frequency traders get an unfair advantage, but the biggest problem was a form of front-running. Stock trades often get split up among different exchanges because no one exchange is offering enough shares to fill the order. High-frequency traders would place “very small bids and offers, typically for 100 shares, for every listed stock. Having gleaned that there was a buyer or seller of Company X’s shares, they would race ahead to the other exchanges and buy or sell accordingly.” So, whichever exc...

I was somewhat skeptical about a recommendation to read a century-old book about stock trading, but Reminiscences of a Stock Operator (annotated edition) by journalist Edwin Lefèvre is an entertaining and illuminating historical novel. The book is written in the first person about character Larry Livingston and is based mainly on the life of the great trader Jesse Livermore. The version of the book I read was greatly enhanced by journalist Jon D. Markman‘s extensive annotations explaining many terms unfamiliar today and giving many back stories to put Lefèvre’s writing into context. The main character makes a fortune and then loses it again several times over, each time gaining new insights into stock trading. The limited regulation of the time permitted extensive leverage and many attempts to corner markets. Common themes are manipulation of the investing public and back-stabbing among big traders. No doubt the many trading lessons woven into this story would have some usefuln...

My son recently set up his first TFSA and has $450 per month flowing into it. His plan is to buy Vanguard Canada’s exchange-traded fund VCN with this money. Once his portfolio grows, he’ll consider adding other stock indexes and other asset classes. After the first deposit, he asked me a good question: “how often should I buy VCN?” He was clever enough to figure out that making a trade every month might be too expensive, but if he waits too many months between trades, he’s giving up potential growth. There must be some optimum number of months between trades. The following factors affect the optimum interval between trades: m – yearly new savings r – excess yearly return of stocks vs. cash c – stock-trading commission Bid-ask spreads are a real cost, but they don’t enter into consideration because they are the same over the course of time no matter how often you trade. From these values we can calculate T – threshold cash balance when you should trade to minimize ...

In the book Market Mind Games: A Radical Psychology of Investing, Trading, and Risk , author Denise Shull argues that rather than trying to control their emotions, traders should tap into their emotions to get better investing results. The main themes of the book are that math is bad, trying to control your emotions is bad, and using the author’s methods would help you avoid losses. To paint a picture of a radical new approach to trading, Shull devotes the first half of the book to rejecting math and controlling emotions. She then goes on to describe her methods in the second half of the book. However, where she gives concrete advice, the tips turn out not to be particularly radical at all. The author’s most direct attack on the idea that traders should control their emotions is to argue that damaged people who have no emotions aren’t capable of making any decisions at all. However, controlling emotions doesn’t mean eradicating them. It means staying calm and thinking before a...

For many people it’s almost impossible not to have opinions about stocks. Even those who use a low-cost indexing approach to investing like me find themselves with a strong opinion about a company’s prospects from time to time. For those who commit real money to their opinions, I have a suggested mindset for trading. Imagine an office building with 1000 people working away on clusters of the latest powerful computers. The workers are former physicists. String theory wasn’t challenging enough for them and they went looking for greater mathematical challenges. Now they are all working together developing advanced trading strategies. The next time you trade an equity imagine these former physicists being on the other side of the trade selling whatever you’re buying or buying whatever you’re selling. I’m not saying this just to scare readers; this is a fairly accurate depiction of the trading universe. I’m a believer in owning equities and taking some investment risks, but tra...

Larry MacDonald reported on interesting research into using “robot traders” to prevent market bubbles. Unfortunately, this research ( paper available here ) by Suhadolnik, Galimberti, and Da Silva fails to address some serious real-world constraints. The idea is that based on the researchers’ model of trading patterns, adding some contrarian robot traders that trade against the herd tends to stabilize stock markets and prevent bubbles. This sounds plausible, but it brings up serious questions about how this idea could be implemented. To their credit, the researchers mentioned one of the practical problems (although it is buried on the third to last page): Where will the money for robot trading come from? “Financial resources involved in stabilizing the stock market is not addressed.” I don’t know if contrarian robots would make or lose money over the long run, but contrarian strategies can definitely lose money for very long periods of time. I definitely don’t trust the gov...

Tom Bradley at Steadyhand reports that the Alpha Group (owned largely by Canada's big banks) is being investigated for conflicts of interest by the Investment Industry Regulatory Organization of Canada (IIROC). The concern is that your trades may not be executed at the best possible price. The Alpha Group seek to divert trades from the TMX to the Alpha exchange. Their initiative aims at "establishing a market place driven by profit and the best interest of the industry." Of course, profits come out of traders' pockets. I try to be wary any time I make trades, which isn’t very often. I check the bid-ask spread to make sure it isn't too wide, and I check that my trade is executed close to the appropriate price.  Most of the time I get the advertised bid or ask price, but occasionally I get a slightly better or worse price. However, I don't trade often enough to judge whether anything unusual is going on. I would think that any extra profit by an exch...

The book Super Trader: Make Consistent Profits in Good and Bad Markets by Van K. Tharp is definitely not what I expected. I thought the aim would be to show me how to make consistent trading profits. Instead it assumes the reader already knows how to profit by trading and needs help sticking to a proven system. Tharp paints a picture where profitable trading strategies are a dime a dozen, but the discipline to follow a system is the real key to success. A lack of discipline can certainly be harmful to investors’ returns, but Tharp offers no evidence that the consistently profitable trading strategies that he repeatedly refers to actually exist. The book anticipates this criticism by ridiculing a “gentleman from England” who took one of Tharp’s courses and complained that it didn’t give him a profitable trading strategy. Tharp’s reply is that the course wasn’t designed to give a methodology; “it is about how to become a peak performance trader/investor,” and “psychology is far ...

If you ever watch come-ons for trading systems you’ll find that they are a lot alike. “It’s possible to make money in any type of market, whether stocks are going up, down, or staying the same.” They promise to teach you how to make money, but there is a catch. It’s true that you can make money in any type of market. If a stock is going up, you can profit by buying a call option. If the stock is going down, you can profit by buying a put option. If the stock is going to stay steady, you can profit by selling both call and put options. The unstated catch in all this is what if you are wrong? The answer is that you’ll lose money. If the companies behind these come-ons really could predict stock price movements, they would use their systems to make money rather than waste time teaching you how to do it. These companies profit from your activity. You pay fees to them for their software and platforms and for teaching you, and they may get part of the trading fees you pay. They ma...

Whenever I buy bonds through my discount broker, the commissions they charge me are hidden. When I want to buy a particular bond, they just quote me a price, and when I decide to sell the bond, they just quote me another price. There is never any mention of commissions. Of course, discount brokers don’t let you trade bonds out of the goodness of their hearts; they make money somewhere. With stocks it is more obvious. You pay commissions and lose some money on the spread between bid and ask prices. Right now I only have one bond. It is a British Columbia coupon for $14,000 coming due 2010 June 18. A “coupon” is a bond that is bought for a discount to the face value and pays no interest until the coupon comes due. So, I paid less than $14,000 for it, and will get $14,000 in June of 2010. To figure out the fees I’m charged for trading this bond I first checked what I could get for it if I sold it: $13,438.14. The cost of buying another identical bond is $13,532.82. So, the total ...

One of the concerns I have about my investing future is my own emotions. One day I may become bold or fearful and make some rash decisions. The resulting trades would probably work out badly. I consider my online trading account to be one of the things that increases my risk of doing something impulsive. Some people say that the solution is to work through a financial advisor who performs the trades for you. I have a much cheaper solution: I avoid logging in to my trading account unless it is necessary. Many people choose to read stock quotes and other investing news through their online accounts. When you do this, making trades is always just a few clicks away. I do my day-to-day financial news gathering anywhere but through my trading account. This small extra barrier of trying to remember my password and figuring out how to make a trade gives me a little more protection against impulsiveness. Usually, the people I mention this to think I’m a little crazy. Is anyone else conc...

It’s hard to see the steady rise of the stock market on a day-to-day basis because of the volatility of prices. Whether you focus on the long-term increase in prices or the short-term volatility determines whether you are an investor or a trader. Let’s suppose that the stock market is expected to rise 10% per year with volatility of 20%. The volatility (or standard deviation) has a precise mathematical meaning, but let’s just say that it creates a return range of 10% plus or minus 20%, or from -10% to +30%. In most years the market return will be in this range. Because there are about 250 trading days per year, you’d think that we could divide these numbers by 250 to get a range for each day of -0.04% to +0.12%, but volatility doesn’t work this way. From experience we know that daily market movements are very often outside this range. The problem with this thinking is that volatility partially cancels out over time. A big rise followed by a big drop may leave the stock price unchanged....

According to proponents of efficient market theory, it isn’t possible to do better than market averages by picking your own investments. New information gets incorporated into stock prices almost immediately making it impossible to profit from this information. On the other hand, there are a handful of people like Warren Buffett who have outperformed stock market averages for so long that it couldn’t possibly be a fluke. Both sides in this argument make a strong case. But who is right? As usual, the answer is somewhere in between. Price vs. Value At any given moment, the price of a stock is determined by the crowd of people making bids to buy and sell shares. If some good news comes out, the stock’s price will shift upward due to the change in bids coming from the crowd. The crowd isn’t necessarily right, though. A stock’s true value, which is based on the company’s future prospects, could be $20 even though the crowd sets a price of $10. But this doesn’t necessarily mean that yo...

Most commentators agree that people should be investors rather than traders. However, it’s impossible to be an investor without trading sometimes (or at least once). This is like telling people not to become smokers, but expecting them to take a puff once in a while. Let me start by explaining what I mean by “trader” and “investor.” A trader is someone who buys and sells stock. We usually use the term “trader” to mean those who trade stocks frequently and base their decisions on recent stock price movements rather than the health and future prospects of the businesses behind the stocks. An investor is someone who examines businesses to try to predict their long term success in terms of revenues and profits. Some commentators stop there, and I know what they mean, but none of this analysis makes any difference unless you actually buy the stock. Investors have to be traders at least part of the time. Let’s say that you are an investor who has found a business you would like to...