Data tracked by traders can prove useful to investors.
Most analysis of financial instruments focusses on historical data. But prices discount future expectations. This method of looking into the rear-view mirror while driving forward can cause both genuine and apparent valuation distortions.
A market, which is highly valued from a historical standpoint, may be low-valued if rapid growth is visible in the future. The opposite situation can arise when expectations of a drop in future earnings leads to a market being priced low compared to historic data.
Market action isn’t solely influenced by investor expectation. It is also influenced by a derivative - trader expectation of investor expectation. Investors use historical data to project earnings, margins and so on into the future. Traders use historical data to second-guess future investor actions.
One functional difference between traders and investors is that the trader is prepared to go short. Another is that traders set stop losses and consider exit options when entering a trade. In a broader sense, investors try to maximise returns without taking other people's actions into consideration, while traders incorporate guesses about other participants' actions into their models.
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In most equity markets, non-delivery trading volumes far exceed delivery-backed volumes. Therefore, it’s reasonable to assume trader action has a large influence on short-term price movements. By their actions, traders reduce bid-ask spreads, create liquidity and generally lend shape to the market.
In an efficient market, no participant possesses the financial resources to impact prices to any great extent. So every participant can make decisions while assuming that their own trades will not trigger major price changes. Nor do participants act in concert in an efficient market.
However, no market is perfectly efficient – big institutions can usually shift prices by sheer volume. The government can always change the playing field. Non-participants like central banks, including the central banks of other nations, also have an impact on equities because they influence trends in currency and interest rates.
Also, even without consultation, or cartelisation, given the same information, people with coincident interests will often act in similar ways to try and maximise their own returns. So there are usually consensus estimates and opinions – less politely, this is called the herd instinct.
There is also a hierarchy of information dissemination. The efficiency of a market depends on that hierarchy and the speed at which information filters down to the lower rungs. Governments, central banks and market regulators always have access to more information than other participants. Institutions usually know more than individuals.
In a market like India, the information hierarchy is very rigid and information dissemination is hit-and-miss and usually tainted by baseless rumours and gossip. So, the Indian market is a long way from being efficient and that makes risk-management more difficult. On the flip-side, this can mean that extraordinary returns are on offer.
A pure investor in such an inefficient market can suffer from information starvation. If he knows less than other participants, his actions are likely to be sub-optimal. This is equally true for a trader. However, it is easier for a trader to gather the information he requires, than it is for an investor.
A trader is looking at price, volume, institutional participation, declared insider trades, derivative cost of carry and so on. All this is public information that is generally available and the same quality of raw information is available to everyone. Of course, somebody with sophisticated hardware and better programming skills can generate more insights from the data.
An investor is looking for much more nuanced detail about the nitty-gritty of businesses. This involves a multitude of variables and is much more difficult to find. In general, a retail investor’s knowledge and actions will lag that of the institutions and the insiders.
Does this imply that India is more of a traders’ market than an investing environment? Indeed, does it imply that any inefficient market is better handled from a traders' perspective? It is a thought worth considering.
There’s no reason why an investor should avoid looking at the typical data that traders track. Much of the time, it will make no difference to their decisions. But once in a while, it could throw up something that is really useful.
Traders also tend to be much more sharply focussed in terms of targets and timelines. While an investor will perhaps, set a long-term price target based on earnings-per-share (EPS) expectations, traders tend to set stop losses that they review everyday.
That one concept, the stop loss, can transform average portfolio performance into excellent. If you’re an investor and you want one tool from the trader’s arsenal, opt for the stop loss.