I spent the first couple years of my career working on trading floors at both a massive bank and a small investment fund. This was a dream for me. I had always been interested in financial markets and was fascinated by big named investors who were smart enough to be able to predict the future of companies, currencies, and the world in general, making a fortune in the process. I wanted to learn from these people, to become one of them. Once I got there, however, I slowly began to realize that professional investors and traders don’t rely on predicting future prices to make money. In fact, at one of my jobs, this sort of speculation was discouraged, and at the other it was illegal.
I came to this realization during my first couple of months on the trading floor. Some of the traders there were trading hundreds of options on dozens of stocks, yet they didn’t follow the news on any of these companies. I remember asking one of them about this and their response was that news about the companies wouldn’t affect their strategy, so it would be a waste of their time to read it. How could this be? Isn’t the whole idea behind trading to analyze all available information on a company to know which way the stock price is going to move? If this isn’t the case, then how exactly do the professionals make money?
To understand this, it is important to appreciate the business models of the companies that employ these traders. Financial institutions are typically considered to be part of the “sell side,” “buy side,” or sometimes both if they are large enough. These two types of institutions have very different strategies.
Sell-side institutions focus on selling financial instruments. Part of their business is to act as a warehouse, buying assets from people who want to sell, and selling to people who want to buy. They will buy only below the current market value and sell only above the market value, capturing the difference between the two prices.
You can see the evidence of this for any publicly traded product, lets use a quote for Apple’s stock as an example. We are interested in the “Bid” and “Ask” fields here. These are, respectively, the highest price someone is willing to buy for, and the lowest price someone is willing to sell at. The midpoint between the two can be thought of as the market value for the stock. If you want to buy Apple’s stock you have to pay slightly more than that value, and if you want to sell you receive slightly less. The “Bid” and “Ask” prices are posted by sell-side traders. Each time they buy at the “Bid” then sell at the “Ask” their profit is “Ask” minus “Bid,” otherwise known as the spread. The spread here at first seems small, as it is only a few cents. However, big sell-side institutions buy and sell millions and billions of dollars of many different products each day. You can see how if you are moving enough products this could become a very profitable business.
This strategy is not too different from any other re-seller, for example, a used car dealership, which buys cars for under market value, then marks them up and sells them at above market value. The difference here is that the price of financial instruments is much more volatile than the price of a Corolla. For this reason, sell-side institutions never want to have too much exposure to any one instrument at once. The job of a trader at these institutions is to track the exposure to different financial instruments and make sure it never gets too high. For example, they want to make sure they never own too many shares of Apple stock in case the price drops sharply. Notice that there is no need to predict price movements to make money here. You simply buy below market value, sell above market value, and make sure you won’t get hurt too bad if the price of one of your products ever moves dramatically.
Buy-side institutions have a very different business model. These are firms which want exposure to financial instruments. They buy with the intention of selling later when the price has gone up, or sell with the intention of purchasing when the price falls. What is notable about most buy-side institutions is their fee structure. They charge fees which are to be paid regardless of performance.
For example, mutual funds, which 46% of households use, typically charge somewhere between 1% and 3% of your total investment amount each year as a management fee as well as when you buy into and cash out of the fund. Similarly, hedge funds tend to follow the 2 and 20 rule. This is where they take 2% of your total investment each year and 20% of profits that they are able to generate (if any). Both of these types of funds are typically investing on behalf of others; they are not taking any financial risk, and are not directly impacted if the fund loses money. They profit when doing well, but don’t lose when they do badly. As with sell-side institutions, traders on the buy-side will make money regardless of whether they can at predicting future financial prices.
It’s telling that professional investors don’t rely on a business model where they need to know whether prices will go up or down in the future to make money. If the people who make their living in finance don’t expect to be able to consistently predict market movements, should anyone else?
The finance industry propagates the belief that there is some way to predict the future, and that they know how to do it. This belief results in everyday people handing over their money to the industry to manage, which keeps their pockets full. It also convinces many people that it is possible to make money day trading, especially now that everyone is trapped at home. Generally, amateur investors try to guess whether a stock price will go up or down based on how they think the prospects for a company will evolve. If you are one of these investors, please keep in mind that this is not how people in the industry make their living because it is a very hard, and likely impossible thing do be successful at consistently.