Friday, April 06, 2018

Types of Trading

There are lots of types of trading. Some of the important strategies are the following:

1. Market-making: A market maker profits from the bid-ask spread in the market, selling at the ask and buying at the bid. This is very apparent in options markets where there is usually a big bid-ask spread. They can hedge their "delta" risk by buying or shorting the underlying security - for example for futures options they can buy and sell futures contracts. For individual stocks - if they are trading a diversified basket they can again hedge using futures contracts (or ETFs). It is possible for individual investors to make markets in small and illiquid stocks - ie. selling at the ask and buying at the bid, but it is a very slow process waiting for people to trade with you.

2. Arbitrage: This exploits pricing anomalies, for example between futures contracts and ETFs for the same underlying index. Short one and buy the other. Occasionally, there are big arbitrage opportunities such as the famous Palm case.

3. Mean reversion: These are generalizations of arbitrage. For example, buying closed end funds (listed investment company in Australian) when they are selling below net asset value and shorting them when they are above. I've done this quite a lot with Platinum Capital (PMC.AX - just selling when above NAV - but actually there is a CFD you could use to short the stock). This is arbitrage between the value of the portfolio and the price of the fund. Statistical arbitrage is a market-neutral mean reversion trade where stocks that have risen in value are shorted and those that have fallen are bought. It was pioneered by Ed Thorp.

4. Selling option premium: This relies on the time decay of options. Most options expire worthless and risk aversion means that buyers should pay in net to reduce their risk. So option sellers should on average win. Again, delta risk could be hedged away in theory. The simplest case is covered calls where the trader buys a stock and sell a call - though actual delta hedging is a lot more complex than that.

5. Information trading: Here the trader knows information that they think will move the security. For example, recently I bought shares in IPE because Mercantile did. I assumed correctly that their analysis must have shown that the underlying portfolio was worth more than the stock price. This is a kind of mean reversion/arbitrage of course and is could also be seen as investing. Even after the company released news of the sale of Threatmetrix to Elsevier, the price didn't immediately move to the new higher NAV.

6. News trading: Here the information is not yet known but a trade is placed to take advantage of it. For example, if I know that Apple Computer will release their earnings but I don't have a hypothesis of which way it will move the stock, I could buy both calls and put options in the hope that a big move will make one increase by more than the other decreases. This seems pretty close to gambling - option prices should take into account the size of likely moves, so you are gambling that the move will be bigger than the market thinks.

7. Trend following/momentum trading: This is what most people think of as trading. The trader tries to take advantage of market momentum. This is the approach taken by many managed futures funds. Much online trading advice is based on this.

8. Hedging: These traders trade to hedge their investment or business positions. For example, an airline buying oil futures contracts to guarantee their future price of oil or an option buyer hedging an investment portfolio. The latter might also sell options to fund the hedging puts.

What have I missed? This paper has an interesting discussion of types of traders.

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