Saturday, December 26, 2009

What are financial markets?

What are the markets? Are financial markets a bunch of stock tickers, varied commodities and a multitude of currencies? Are they really the products they represent? Is GLD really gold?

All of the above questions were things I never thought about before I became seriously interested in the markets. I did view the stock market as stock tickers with ever-changing prices. And I did think that these prices reflected the value of the company it represented, since in financial theory, all markets are efficient and traded by rational participants. These assumptions had to be true, since many of the financial markets are traded by the brightest people with the latest and greatest technology. Who am I to question those who are smarter and more experienced than I am?

In the beginning, my approach to trading was haphazard and I my results showed. I made all the rookie mistakes and quickly began to question whether I could continue. It was at my lowest point in my first year that I decided I needed to change my approach to trading. I started to view the markets in a different lens, from the eyes of great trend-followers through the books I've read, and began to understand what a "market" really was.

Market prices for any tradeable security is not the actual value of the company, rather, it is the sentiment that the participants hold of the company discounted for the future. The best example of this is an earnings report. For those who have followed the markets, you've seen many instances where the earnings report for a company either beats or misses estimates and the stock reacted in the opposite manner of what you expected. And why would the company's stock price do the opposite of what they have reported? Because the sentiment of the major players in the company's equity holdings changed, regardless of what the reasons were. As traders, it is not our job to pinpoint what piece of information changed the complexion of the stock, it is our job to react to changes in the prices and act according to our system.

A great example of this was DNDN (Dendreon, a pharma company with a promising prostate cancer drug) on September 14th, when the price of the stock shot up close to 15% from 24 to 27.50s and people were clamoring for the reason for such a move. The company repeatedly said there wasn't any news or findings on their pipeline drug. There HAS to be news when a stock makes such a move, doesn't it? The point is, pricing creates news and sentiment creates prices. Yahoo Finance will find "reasons" for a move because people want to hear and believe in fundamental changes. I just chuckle when they pinpoint a market rise due to some number and the next day, they attribute a market fall due to another number.

Another great example of sentiment in play involved the same company on April 28th. It had an important presentation on their lupus drug during the after-market hours and people involved in the stock were waiting for any leakage in information. In an otherwise quiet time in the market at 2pm, I saw the stock plummet from 25 to 7.50 in mere minutes. The actual change in prices on my screen was awe-inspiring. Apparently there were some negative rumors on the drug and equity holders panicked out of their holdings. The stock was halted and the Nasdaq exchange began to investigate the issue. It turned out that these rumors were false and the stock opened up higher than the previous day's price. However, if they were true, what would have been the fate of those who bought and held onto their positions? And if the markets are made up of rational players, how would you explain such a violent downmove under this assumption? Remember the words of John Maynard Keynes, "The markets can remain irrational longer than you can remain solvent."

Another aspect of the market that needs to be understood is that once information on a company is public, the price of the company has already reflected such information. For example, Warren Buffet bought out the remaining shares of Burlington Railroad (BNI) for 100 per share in November 3rd. On market open, the price of BNI already reflected such a change, opening up at 97.85. Reasons for the difference in price reflects the probability that the deal goes through, since the announcing of the deal is not the closing of the deal (a good example is Harman Kardon, symbol HAR, look at year 2007 when KKR proposed and eventually backed out of a 120 buyout deal). Regardless, the meat of the move from the 70s to the high 90s was immediately reflected the day of the announcement. There are people who know more than you earlier and faster than you ever will.

I will end with explaining why I call participating in the market, the "game." In this psychological game, a game where you are pitted against an untold number of participants clawing at your money, there are rules set forth that many have tried to break but none have succeeded.  A few of the most important ones are as follows, in no particular order:
  • No one entity can stop the eventual price of a company, no matter how much capital and respect they command, a great example being Long Term Capital Management's downfall. 
  • Discipline is key to surviving your inevitable losses and reaping great rewards.
  • Fundamentals, in the very long run, do affect the pricing of companies. Look at Enron, Lehman Brothers, Worldcom, etc. What will you do in between this period of time?
  • Risk management is the single most important factor you must understand, practice and respect in this game.
  • No one ever knows what the market will do in the future
  • There are no holy grails in this game. 
  • There is no one right way to trade the market but there are wrong ways.
Feel free to post comments, I will respond and appreciate every one (reminiscences from experienced traders very welcome as well).  Also, if you would like me to discuss a certain topic in my next post, post it in the comment section as well. Until then, never leave home without a stop-loss.

4 comments:

  1. Really great post Henry! Good examples, and good points. Can you elaborate more on your last bullet: "There is no one right way..." And also give some real life examples that you've seen?

    I'd also like to hear about your take on "discipline" and "risk management"

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  2. Thanks for the comment Steve.

    There is no right way to trade for the simple fact that there is no holy grail. There is no one system that will work in every type of market. Technical analysis does not work all the time, neither does any other school of thought or derivation of those schools. However, what the financial crisis, dot com bubble, LTCM and 1987 taught us is that there are wrong ways to approach the market.

    Discipline and risk management will be later topics, both have many commonalities and much of the time, are the same.

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  3. Just for accuracy sake, Dendreon's (DNDN) drug is for prostate cancer not lupus

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  4. Yes, sorry, I was thinking about HGSI. Thanks upanddown.

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