Get Out of the Shark Tank

 | Dec 07, 2012 | 3:30 PM EST  | Comments
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In my day-to-day activities, I spend a lot of time talking to folks involved in the markets. I am an equal-opportunity chatter: I talk to investors, traders, growth guys, momentum guys, risk arbs, and even the futures and options traders. On occasion, I troll the Web reading various trading and investing Websites and chat boards to get a feel for sentiment and activity. The more I read, the more I have a question for all the retail and individual traders out there.

Why do this to yourself?

Individual traders seem determined to give away any edge they may have and become donors to the large funds and the Wall Street profit machine.

Everyone seems to be trading the same stuff. Almost every individual trader I run across has the same stocks on their screens. They are all trading Apple (AAPL), Google (GOOG), gold exchange-traded funds, Salesforce.com (CRM) and other so-called hot stocks and ETFs. All of you are poring over each day's edition of a certain daily business paper looking for high-ranked stocks with the same technical patterns. A huge percentage of traders are trading the same stuff in almost the exact same way and wondering why they are not more successful.

Think about what you are doing for a moment. You are trading the same highly liquid, popular stocks that all the black boxes and leading quant funds are trading every day. You are competing against guys like Jim Simons, who has so much computing power he had to install special air conditioners. The guys on the other side of the trade are likely to be Steve Cohen and his guys at SAC, who are masters of short-term trading, or the three guys with PhDs in computer science and quantum physics just blocks from the New York Stock Exchange.

When you trade what everybody else is trading, you are getting into a shark pool wearing a meat suit.

I spent a good deal of time this week talking about the powerful market anomalies provided by insider-trading information. Although I use it in my activities as an investor, I am just befuddled as to why a trader would not use such a powerful edge. You have an easily assembled list of stocks that have a strong statistical probability of moving in a certain direction. Companies where insiders have been selling stock in clusters have a tendency to go lower. Those with the CEO and CFO buying or cluster buying by insiders have a very pronounced expectation to go a lot higher over the next three to six months. Why aren't you running your patterns and statistics on these lists where you have a huge edge and no competition from other traders?

Everybody and their brother seems to trade off the new-high and top-performing stocks lists. In the past year, I have been doing a fair amount of work on establishing hedged portfolios using stocks trading at new lows. What we have found is a marked tendency for the stocks that are down more than 50% in the past year to stage enormous rebounds. When we ran the data in the first week of November, we had four stocks that made the list. Of the four, Abercrombie & Fitch (ANF) and First Solar (FSLR) are up by more than 30% in less than 60 days. Why are you trading the same stocks everyone else is, the ones where large quant funds are gaming against you in highly liquid stocks?

I have had traders tell me they have to be in the same things as everybody else because that's where the action is in the market. That's the same reason they go to the craps table as well -- and they usually lose. If you want to gamble, go to Las Vegas. At least you get free cocktails in a casino. To succeed in the markets you have to approach it as a business. Most individual traders do not have the same liquidity concerns of the big funds and don't need to worry about getting off a million shares at a clip during the day. You have the advantage of being able to trade what they cannot. You are not here for action, you are here to make money. At least I hope so, because action junkies go broke.

There are several exploitable market anomalies you can use as an edge and find opportunities way from the competition. Traders tend to want to be in high-volatility stocks to take advantage of price swings. Sounds good, but did you know that according to several academic studies, low-volatility stocks tend to outperform higher-volatility stocks? I ran a screen of low beta-liquid stocks and looked back at 2012. I found any number of successful technical patterns that would have offered huge trading opportunities. I have done studies of S&P 500 stocks trading below book value and found extreme outperformance. I looked at my list of candidates from January and found a plethora of tradable patterns that my technical-analysis-oriented friends tell me work well.

If you are trying to day trade the same stocks as all the other day traders, you are picking up dimes in front of bulldozers. It is highly likely that a bigger, faster trader will eventually push you under the bulldozer and scoop up all your dimes. Change your time frame and your universe. If your methods and tools are valid, you will make more money than doing what everyone else does.

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