Saturday, October 2, 2010

The New American Normal

New York Times article "The New American Normal" (September 27th, 2010) states that there may be heterogeneity in the ability of traders to make money during various market conditions. Corrections doesn't see this as being the case. We expect that a trader has an equal opportunity to have a positive expected value on a trade whether the market is highly volatile or not.
Fragmentation holds sway. The stock market used to be a fair proxy for the state of the economy. Now it’s a market of traders, not investors. They want to know what the spread is today and tomorrow; they can make money on the way up or down; they care far less about U.S.A. Inc.

So the market goes where it goes — up of late but largely directionless (which makes it harder on those up-or-down traders) — while out on Main Street the struggle to make family payroll continues. People work longer hours, they juggle how to cover their kids’ needs, how to de-leverage just a little — and they’re still meant to “consume” for the economy’s sake.

First, for the ill-defined class of "up and down traders", we might consider they do better when the market is highly variable. However, a quick view of the 30-day average S&P 500 price variance dispels this notion rather quickly (click to enlarge). If anything, Corrections expects that the average trader did better in the low volatility areas than the high (NBER recession dates are colored in grey).

Either way, it's ludicrous to claim that traders like one market environment over another, unconditional on their current assets. Unconditional on current assets, a trader who believes the market will be constant will be able to make money off selling a put below the current price (believing a stock won't go below the sum of strike price and premium) and selling a call above the current price (believing a stock won't go above the sum of the strike price and premium). A trader can flip sides on the trade if he thinks volatility will be high. If the market is undergoing a constant increase, then demeaning by the expected trend yields the same trading strategy. Whatever the market conditions, it's rather simple to construct trading strategies that require simple adjustments. The level, rate of change, and volatility won't matter.

The only manner in which changing market conditions may matter to a trader is an increase in the cost of capital (for deals requiring leverage) a decrease in their ability to utilize specific knowledge or expertise (analysis of mergers and acquisitions may presumably require expertise and contain a cyclical trend), or if the trader already owns positions in the market and does not want those to decline--distinctly separate (though difficult to distinguish without data on specific trends) from their ability to make money off present market conditions.

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