One of the main points I make in my book, "Invest Like a Shark", is that you don't beat mutual funds by investing and trading like a mutual fund. There is no way you can compete effectively against a fund by doing the same thing they do. The funds have much better research, more capital and better access to information.
To beat big mutual funds and hedge funds, you have to think differently. For small investors and traders the big advantage that they have is speed and the ability to change course quickly.
In recent years computerized trading has become a much more powerful force in the shorter term than big funds. Ironically the computers are doing exactly what I suggested in my book. They aren't trying to beat mutual funds and hedge funds directly. They are using speed, fast reactions to news and the ability to change course quickly to beat them.
The computers are acting like sharks in order to beat funds. There is some satisfaction in knowing that the theory as to how to beat funds was correct but, once again, small traders and investors are faced with the same problem of competing against entities that have much better information, capital and technology.
The question we must ponder is, not how to beat computerized trading by doing what they do, but how do we develop methods that will give us a different edge. It is difficult question because everyone in the market is always looking for an edge. The computerized traders stole the edge that the little guy used to have so now we need to adapt.
The first step in the process of developing an effective strategy is to understand the strategy used by the competition. Computerized traders use a variety of approaches but there are two main categories. The first category is reaction to news. Earlier this week we saw a good example of how computerized traders react to headlines when the Wall Street Journal reported that the Trump administration was considering the elimination of some tariffs against China. There was an instantaneous spike as news algorithms were triggered as the headline crossed. They moved faster than any human could and the market was up substantially in seconds.
News is often used also in the context of earnings reports. Much of this take place after normal trading hours but you can see how fast the reaction is as earnings news is released.
The second major category of computerized trading is pattern recognition. Computer programs are designed to trigger when certain conditions come into play such as a gap-down open or a gap-up following a run of many positive days. The algorithms that are designed can be extremely complex with numerous factors taken into consideration. Their power comes in that there are no emotions involved. They execute their programs without any feelings and that discipline serves them well.
There are two basic ways to change your strategy in reaction to computerized trading. The first is to change your time frame. The computers tend to act in extremely short time frames in some cases and slightly longer in others. The spike on the tariff news this past week only lasted about 15 minutes before it reversed. Don't try to compete in that time frame because you aren't going to win. Look to act after the move has occurred and the market is reverting to normal conditions.
If you are a longer-term investor these short term movements should simply be ignored, however they create much frustration for many because the movement appears so random. It shakes the confidence of people when a stock can move so much on what appears to be nothing.
This is the basis for the second main approach to dealing with computerized trading, which is to focus more on pricing inefficiencies. The computer programs are focused to a much greater degree on price action rather than fundamentals. They tend to push stocks to extremes in both directions that have little to do with their individual merits. This creates opportunities but the difficulty is that it means that we have to understand fundamentals to greater degree. In order to determine when the price movement is artificially impacting a stock we have to have some notion of a stocks 'intrinsic value' which can be a highly subjective calculation.
The topic of how to compete against computerized trading would fill a book but the main point to understand now is that you don't try to compete head-to-head. You will never be as fast as the computers or have the access to capital and information that they do. You must cultivate a different approach.
I'll be discussing this much more on RealMoney.com and may even write that book.