Should You Focus Your Trading on Stocks?

Stocks are the most widely held and discussed securities in the United States.  Of all the security types, they are the only one that has penetrated popular culture and become a topic of kitchen table discussion.  When Joe Sixpack refers to “the market” he’s talking about stocks, not bonds or commodities or derivatives.  This is seen as myopia by most financial professionals – while stocks matter, they really only matter at an economic level in the aggregate.  Any individual stock is small in terms of capitalization when compared to the T-bond market, mortgage bond market etc.  In terms of size, bonds and index futures rule the roost and individual stocks are a backwater.

This pro-bond/anti-stock bias is apt in the context of very large funds and bank trading desks trying to move huge volume.  If you want to put billions of dollars of capital into play, you’re limited to a small number of markets – a few bond markets, index futures, oil, foreign exchange.  Individual stocks just don’t play.  But for the individual trader with a small amount of capital, stocks have some intriguing characteristics.  There are a huge number of stock issues out there – the New York Stock Exchange lists about 2300 stocks and the NASDAQ about 2800.  This has several interesting effects.  First, stock speculation strategies have the option of picking their stock, oftentimes looking for rare conditions and none the less finding multiple stocks that fit them.  Second, there is a wide range of performance among stocks – regardless of market conditions you can find some stocks that radically out-perform the market and others that radically under-perform.  Third, the talent of the competition you’re speculating against is frequently weaker.  You can pretty much guarantee that any desk which actively trades T-bonds has their best people on it, but what about trading Darden Restaurants Incorporated (DRI)?  If the desk even has someone trading DRI, it’s going to be the B team – hell, probably the D team.  Realistically a major desk won’t even bother.  This creates an opening for the inexperienced little guy.  Mid-sized stocks are a sort of trading minor leagues where a rookie can learn the ropes without having to play against the veterans.

Another major advantage of trading stocks as opposed to futures or bonds is the granularity with which you can control your position sizing.  Stock is generally bought and sold in 100-share lots, so depending on share price a lot is generally between $1,000 and $10,000 of stock.  This is a fairly comfortable size even for an under-capitalized trader.  Better, most brokers now offer fairly painless support for odd lots (amounts of stock other than 100 shares), so stock positions can be tailored to a trader’s available capital with very fine granularity.  Contrast this with futures contracts, where for example a single crude oil contract (ticker:CL) as of this writing represents about $93,000 of oil.  That’s not so easy to swallow for the little guy.  To mitigate this problem, commodities futures tend to have very low performance bond requirements – you can trade that CL contract with only $9,000 in your trading account.  This lets the little guy in the door, but tends to lead to massive over-leveraging which in turn causes the little guy to blow out his account.

The public fascination with the stock market yields yet another benefit to the would-be stock speculator.  The zero-sum nature of the market means that in order for one participant to win, another must lose.  That in turn means that if you want to make money there must be a sucker in the market willing to give it to you.  Or if not a sucker, at least someone with an unfortunate situation who is willing to lose money to buy their way out of it.  But ideally you’re looking for suckers.  And where might these suckers be found?  Probably not the T-bond market, full of the best traders from the major firms and funds.  But stock market mania causes numerous people with no trading experience whatsoever to jump into stock speculation.  Congress even gets into the act by promoting the use of 401K and IRA retirement accounts which frequently end up stuffed with speculative stock bets.  If you wanted an endless supply of suckers, well, there you go thanks to the fine folks in DC.  Of course, the entertainment-first/knowledge-second financial media (MSNBC, I’m looking at you…) drums up another herd of less than savvy market participants.

Now, all that sounds pretty good.  But there are some serious downsides to trading stock.  The first is that in general all stocks are a lot alike.  A big portion of the price movement of a stock occurs as a result not of changes in the company’s prospects, but as a result of a global change in the appetite for investment risk.  Those changes affect the price of all stock to one degree or another.  What this means is that stocks are hard to analyze in a vacuum.  Some level of spread analysis against the broader stock market is generally required to get good results.  Spread analysis is simply comparing the prices of two things to see how they move relative to one another.  Spread analysis done correctly is a fairly mathematically intensive – the speculator needs to understand correlation, regression, factor analysis etc.  This is an obvious impediment to success for the mathematically unsophisticated, and likely goes a long ways towards explaining why the public at large fairs so poorly in their stock speculation.  But if you’re fluent in statistics there’s an obvious edge to be had.  In fact, many proprietary trading firms that hire new traders work statistical analysis of equities exclusively because they feel an edge is more easily achieved there than anywhere else.  I don’t disagree.

OK, brief pause.  I’ve tried this entire post to use the word “stocks” instead of the word “equities”, but I slipped up.  Equities and stock are in essence the same thing, but the public talks about stocks and the financial world uses both terms.  Generally “equities” refers to the entire market, but individual issues are still a “stock”.  I suppose it’s a case of accountant-speak run amok, but part of the point of this blog is to teach the jargon, so I’m going to use the two the way I would naturally and let the readers figure it out.

So on the pro side for trading equities there’s the large number of stock issues outstanding, the lack of institutional interest, and the ease of position sizing.  The cons are an inability to trade large size and the need for analysis against the broader market.  As a whole I’d say that’s a pretty attractive mix for the little guy.  The problem I see is that you can’t learn the markets as a whole by studying individual stocks.  If you were going to focus on just one thing, it would have to be bonds and their derivatives because as they go, so goes the market.  So seriously consider speculating in stocks, but be sure you spend at least as much time studying bonds.

 

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