One Trade, Two Winners

For every stock trade there is a buyer and a seller.  Depending upon what happens, there is also a winner and a loser.  Is that the whole story?

Background

Occasionally the Old Prof accepts a gig as an expert witness in a legal proceeding.  One of these occasions involved an interesting situation.  The company in question was dramatically affected by certain economic events.  Were this not true, there would be no story and no court case!

The events in question sent the stock lower, much lower.  One of the questions in front of the court was whether the stock continued to be a suitable choice for those administering the portfolio in question.

How Laymen Decide

It is pretty easy to guess how the average person looks at this.  Guess what?  Judges and juries are not much different.  If a stock goes up after the trade, the buyer was right, and the seller was wrong.

There is little understanding that a correct decision in an environment with many unknowns may result in a losing answer.

Briefly put, the concepts of "correct" and "winning" mean two completely different things.  There may be an overlap between the two sets, but they are not identical.

How Experts Decide

Experts, including regular readers of "A Dash" know better.  It is important to think in terms of risk-adjusted returns.  One example might be a biotech company that is about to announce the results of an important drug trial.  Suppose the stock is trading at $4/share and will either move to $18 or to $1.50 depending upon the results.  There is a simple calculation to determine the expected success required to justify the current stock price.  That might be a valid price for an investor able and willing to make many such trades.

Even if that calculation showed the stock to be substantially undervalued, the investment (speculation?) is not suitable for everyone.  Playing with one's retirement or the kid's college fund is not advised.

To summarize, let us suppose that the company circumstances changed suddenly and dramatically.  Let us further suppose that the stock value, on an expected value basis, was attractive.  It could still be correct for risk-averse investors to sell, and those able to assume more risk to buy.

Both sides of the trade are correct, regardless of what actually happens to the stock.

Opportunity Cost Differentials:  Another Example

Let us suppose we faced a pure arbitrage situation.  There is a deal that is 100% certain to close (or as near to that as we can get).  The only question for the investor is whether to hold the position until the deal is paid off, or to accept current prices and move on to a new trade.

The answer varies with the investor!  It depends upon what alternative opportunities have been presented, and perhaps even on the interest rates they have negotiated with their banks.  It may be quite correct for one party to sell and another to buy, the position moving to the party with the lowest opportunity cost, and (perhaps) a higher risk tolerance.

Time Frames:  Another Example

The most difficult application relates to time frames.  Let us suppose that you were asked to make a single investment decision right now.  You were not allowed to change your position (unrealistic, but bear with the example for the moment).

The question is whether to buy the S&P 500.  You will be judged over the following seven time frames:

• One minute
• One hour
• One day
• One week
• One month
• Six months
• One year

In practice, anyone can and should change opinions with the circumstances and facts.  Having said this, at any moment the answer might be different depending on the time frame.

My colleagues at RealMoney make a lot of market forecasts.  Sometimes their disagreements are not really about the fundamentals of the market, but about time frames.  Today, for example, Doug Kass was bullish in the short term and more bearish for the intermediate term. He has even instituted a quantitative rating system, a nice touch.  As regular readers know, we have great interest in his trading calls, especially when he sees a bullish signal.  Bob Marcin, another of our favorite commentators turned more bearish.  After some discussion, (subscription required for all of it) Bob wrote as follows:

	Robert Marcin
	Back To Dougie
	6/17/2008 11:26 AM EDT

Clearly we have different definitions of time frames. This is an intermediate call and that means the next 6-9 months. My definition of short term is less than 3 months, but not daily. You go all in and reverse in a day. We might be more on the same page than you think.

The key point is that both may be making an accurate prediction, given their respective time frames.

Our Take

Time frames are absolutely crucial.  Our own market view is bullish over the rest of the year, but bearish for the next month, based on our TCA system.  We do not make major adjustments in long-term accounts based upon our one-month forecasts, but we use it for "leans" and entries and exits.  We occasionally make intra-day trades when circumstances warrant.

The Result

Two parties can make a trade based upon different time frames, and both can be correct.  Even a single investor using multiple models may get conflicting signals.

The success of a strategy should be evaluated based upon the specified time frame, the acceptable risk, and other factors.

An Interesting Question

Much of the trading volume is now based upon systems where trading success is measured in minutes or even seconds.  Monday's volume was about 25% lower than expected, widely attributed to the exciting conclusion to the U.S. Open playoff.  This means that many traders left money on the table by watching golf instead of implementing their normal strategies.

What was the opportunity cost of the golf tournament?