The Stock Trading Markets: Traders and Market Makers and Individuals

A request for people who are reading my articles for the first time: Please start reading the articles in chronological order – First article First. This will ensure that the concepts presented here are easy to grasp and the continuity is maintained.

It has been sometime now, and I’ve published a few articles. Some were well appreciated; some were criticized with claims from individuals about how they were able to make good profits from equities. Anyways, I tried to prove with calculations and historical facts that it is really difficult to consistently make money in the market.

However, no one ever pointed out a very commonly observed fact: How are the traders & market makers - who are either working for investment firms or doing trading for a living – how are such people able to survive? How do the ones employed as traders at investment firms able to keep up their job, and how are the ones who are trading for a living manage to earn a livelihood. Well, the fact is that they do make good handsome profits, and they do manage to keep up their jobs and livelihoods.

The concept of EFFICIENT MARKETS: This is a famous story about two finance professors who were walking on a street. Suddenly, one of the professors says to the other, “Wait, I think I saw a 100 Rs. note lying on the street a few yards back”. The other professor stops, thinks for a while, and replies, “It’s IMPOSSIBLE. If there had been a 100 Rs. note lying on the street, it would have already been picked up by someone.”

Actually, what is implied by the above short story is that there are NO FREE MONEY opportunities anywhere in the market i.e. no one can get money for free. If there are free money opportunities, they would already have been utilized by someone else – either as a whole or in bits and pieces. “No free money” is equivalent to NO FREE LUNCH – as commonly heard in the corporate world.

Continuing the explanation for the story above – let’s say you are walking with a friend on a lonely street. Suddenly, you see a few 1 Re. coins lying on the street. Immediately, you and your friend start collecting the coins. Let’s say there are a total of 100 coins lying on the street. Assuming equal efficiency of you and your friend for collecting coins, and each of you take approximately 1 second to collect a coin, then the total 100 coins will be collected in 50 seconds – 50 by you and 50 by your friend. Now, if instead of only 2 of you, let’s say you are walking in a group of 10 friends, and the group spots the opportunity to collect 100 coins lying on the street. Assuming same 1 second collection ability, each of the people in the group will collect 10 coins, and all the 100 coins will vanish in just 10 seconds. Extending the group size to 100, the coins lying on the street will vanish in just 1 second –with each individual pocketing 1 coin, on an average. For 1000 people, only a few will be able to get the coins – some may get more than 1, majority of them will get none. Assuming that coins are divisible, in most of the cases, 1 single coin may be shared by many individuals.

This is exactly what goes on in the markets. The moment there is any news of profitable opportunity, the BIG SIZE of market participants ensures that the profit making is done immediately. Around 2-3 years back, Balaji Telefims (The Saas-Bahu serial TV Company led by Ekta Kapoor), was trading at Rs. 105. It declared a dividend of 16 Rs. a share. Within 1-1.5 minutes the price of the stock reached 121-122 Rs. I acted on this news an hour later and purchased the shares at 122 Rs. After the dividend expiry, the price fell back to 102-103 levels (later even to 85 Rs.). I got the dividend, but I got nothing better than the market price, instead I paid more than the market price after the ex-dividend date. Anyone trying to make profitable trading on such news will have to remain alert and keep a vigil on every single news item that comes out. Not only that, he should also be fast enough to act on the news and place the trades to book profits. Can we individuals do it?

We should understand and realize this fact very well, that the market is full of market participants. Any piece of news, any information that is publicly made available, is utilized immediately in the market. No body can be sure of making exceptional returns in the market by utilizing the publicly available information – In essence, the MARKETS ARE EFFICIENT – which means any news that affects the price of stocks, is IMMEDIATLETY REFLECTED in the stock price (with a change in stock price).

I see people reading Economic Times, Business Standard and Business magazines. They watch business news channels, CNBC, Zee Business, NDTV Profit – all attempting to extract valuable information to take profitable positions for trading or investments. Ultimately, they fall victim to the Efficient Market Hypothesis. They end up buying stocks which are already having the effect of the news included in the stock price. The news can be anything –Company bagging orders worth crores, company declaring a dividend or stock split or other corporate action, company declaring handsome profits, etc. etc.

A colleague of mine acted on a stock split news of a penny stock: IQMS Software. The stock was trading at around 8 Rs. when the news of 1:10 stock split came in. Immediately, the price started to increase and touched a high of 13 Rs. My friend bought this stock in big numbers at 11 Rs. After the stock split, the price had changed by a factor of 10, i.e. his buy price of 11 Rs. was now Rs. 1.10 and the no. of stocks he bought was multiplied by 10 times. He invested a total of around 1.5 Lakh Rs. for purchasing this stock. However, after the split, the stock price started to decline, touched a low of 0.36 Rs. and as of today, it is 0.75 Rs. My friend is waiting since last 2 years just to recover his money. The stock has never made to his buy price of 1.1 Rs.

Let’s take a very recent example of Tuesday 29^th May 2007. Indian stock markets went down by around 1.5% -which is a significant decline in the overall market. The reason – China increased the stamp duty on stock trading by 3 times – from 0.1% to 0.3%. Could someone please tell me what has the Indian market to do with Chinese trading charges? At the end of the day, the CNBC Indian Business Hour tells the reason that “Asian markets were affected by Chinese decision, so the Indian markets went down”. Fair enough – what can we individuals do with such news and how much can we benefit from such news – only God can tell. Everyone can give justification for what has happened in the past. Declaring something for future is a dangerous task. Next time will you sit and watch the news coming from China? Thailand? Vietnam?? Definitely not.

Coming back to what I mentioned in the initial part of this article – traders and market makers making profits. They make profits because they have to – otherwise they will not survive. They have to act on every piece of news and take positions accordingly; else they will be out of business in no time. That is what affects the market. Hundreds of such traders, working either individually or employed with investment firms – keep making the trades on every single news item. They loose money, they make money. At the end of the year, they have to show a net profit; else they are shown the door. A typical trader employed at a reputed investment firm gets a fixed salary of around 9-10 lakhs per annum. However, his performance bonus can be as high as 500% of the annual salary, i.e. 50-60 lakhs – solely dependent on the profits he makes from his trades. In 2003, a friend of mine, MBA in finance from top grade management institute in India, employed at a reputed investment firm, had an annual salary of 12 lakhs. He made a handsome profit and got a bonus of 60 lakhs – making it a total of 72 lakhs! However, the next year he suffered losses. Immediately, he was issued a warning from his boss – signaling an exit from the job. He switched the job and today, he’s happy as a consultant with a consulting firm based in Mumbai, paying him a CTC salary of 14 Lakh. You ask him about becoming a trader and his response will be – “It’s a dirty business, stay away from it”. The same will be my response to someone asking me a similar question. The investment firms usually always show profit, because majority of their profits come from brokerage and other deal making commissions. Coming to trading side, at any given time, there will be some traders making money, some loosing money. Even if there are net losses from the trading activities, it will be compensated by the brokerage profits. Winning traders get a share of the profits they make. The loosing traders are kicked out of the job after 1 or 2 warnings, new ones are recruited to replace the loosers and the game continues.

As Mr. Taleb has rightly mentioned in one of his interviews – “If you put enough monkeys on typewriters, one of the monkeys will type a word which is grammatically correct, just by chance. But would you bet any money on the same monkey that he's going to write another correct word next? Definitely not! You know that because of the sheer size of the sample, you're likely to find a lucky monkey once in a while. But will he be able to show consistent performance?”

The same applies to the traders – profits in one year do not guarantee profits in another year. Even they fall victims to market activities and randomness. The moment traders find they are in a loss or have received warnings, they get the signal – either they switch jobs to other investment firms or change the stream (like my friend did). Overall, the common man sees only profits of the firm as a whole, primarily coming from brokerage commission or advisory services on M&A deals or similar transactions.

Then how about the people who are trading for their own living or traders who are consistently making money and are employed within the same firm for years? They have to trade within a very tight profit margin – say just 0.1% to 1% levels. Then how do they make money? They have to trade very frequently, sometimes buy and sell within a minute! They trade with big capital and multiple times. Huge trading volume ensures lower brokerage charges, and multiple profit opportunites (along with the limited losses). These people are experienced and educated enough to know what they are doing, how they have to do it and what implications their trading actions will have.

What’s in it for individuals like us – basically, NOTHING! The reason I mentioned all these details above is to give you a picture of the trading world. We individuals, employed as salaried professionals or running our own business/shops, cannot keep up our trading activities like the professional traders – nor do we have the knowledge, capital and professional experience to control our losses and make smaller profits multiple times. When we trade, we are pitted against these professionals, who are making the markets. We all fall victims to the market trading activities – majority of the times making losses in intra day trades.

It’s a highly efficient market; acting upon news is nothing more than fooling ourselves. Either stick to your actual job/profession and be sincere to it or become a fulltime trader – Nothing in between will work as far as the trading activities are concerned.

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