Mr. Galen Cawley kindly provided a link to a dated, but still interesting article entitled, "An analysis of the profiles and motivations of habitual commodity speculators". This comment was on William Weaver's post: "Study shows why it is so scary to lose money". I found this article provocative because when I was younger, some of my innate instincts were similar to the habitually losing commodity speculators'. I suspect everyone who reads this article will see some foibles he has overcome (or needs to overcome) for self-improvement. To summarize the article:

1) Most speculators use too much leverage.

2) Most speculators don't hold their positions for sufficient time.

3) Most speculators don't use stop loss orders. (However, the authors didn't differentiate between actual stop-loss orders and mental stops. The point was they don't cut their losses.)

4) Most speculators prefer a serious of "modest" short-term profits versus slowly accumulating long-term gains in a single position.

Bottom line: They found that the average speculator had a win/loss percentage of 51.3% and the best speculator in the study had a win/loss percentage of 80%. However, he still lost money because of his low profit factor. Despite great win/loss ratios, the average trader in the study is a career net loser. It's a Wall Street platitude that "no one ever went bankrupt taking a profit." This study shows that the platitude is false.

Kim Zussman comments:

"Most speculators don't hold their positions for sufficient time."

"Most speculators don't use stop loss orders… The point was they don't cut their losses."

Which is contradictory because many deep losses reverse eventually ("every price is hit twice")*, and often the correct trade is to wait for losses to reverse (and often it is not). Taken together, this means "ride your winners and ditch your losers." Isn't that trendfollowing, and if so, what if the (currently traded) market is not trendy?

*except Nasdaq 5000 in our lifetimes.

Victor Niederhoffer comments:

One has not read the article, but would wonder whether speculators would lose as much if they showed opposite traits. However, the characteristics noted all would lead to greater vigorish and this is where most of profits from the market makers occur. Everything that happens is guaranteed to increase the profitability of that vigorish to the house or top feeders.

Rocky Humbert responds:

If one attributes the speculator's losses entirely to transaction costs, then one's performance can be improved by simply having fewer transactions. One wonders whether there is an a priori relationship between all of w/l ratio, profit factor and quantity of transactions? Splitting hairs, I quarrel with your choice of the word "guaranteed." A much wiser man taught me that the only things guaranteed in life are "death and taxes."

Jordan Low comments:

Macro traders should be long gamma as markets can stay irrational, while value traders should be short gamma especially if they are positive carry and see no devaluation/fraud risks. I think it all depends on your style of trading.

Victor Niederhoffer writes:

One would say this is perfect as one trader should always be one way and the other trader should always be the other way. that is guaranteed to make the top feeders a perfect guaranteed profit. I say the above in all seriousness and respect to the high thinking Mr. Low.

Rocky Humbert comments:

Mr. Low articulately differentiates between arbitrage/positive carry, mean-reversion (providing liqudity) and trend-following (taking liquidity). Arguably every single trade or investment fits into one of these categories. But I'm confused and intrigued by Vic's comment about "top feeding".


1. Who exactly are the "top feeders" and should we buy their stock?

2. Are the top feeders always the same participants? If they always make a "perfect guaranteed profit" then how can they ever slip from their perch of being a top feeder? (Were EF Hutton, SW Strauss, Shearson, SmithBarney, Dillon, Kidder, Drexel, Revco, Bear, Lehman, Merrill once top-feeders?)

3. And if they do eventually slip off their perch of "top feeder" — then how does one argue that they ever had any advantage? As opposed to being just another opportunistic profit-seeking participant?

Theoretical questions of course — but they challenge the hypothesis.

Yishen Kuik comments:

Seems to me there is some kind of law of conservation going on. Usually if win-loss is very favorable, avg win > avg loss, then frequency of trades is low. If win-loss is very favorable, avg win < avg loss, then frequency of trades is moderate. If win-loss is only very slightly favorable, avg win > avg loss, then frequency of trades is high.

etc. etc. …. all solving for a reasonable profit factor.

But if you are doing something quite different or if you are early in a wave, you can have an unreasonably high profit factor. Then again, there is always the argument that low profit factor strategies with low capacity are the ones with the longest half lives.

Jordan  Low replies:

I appreciate the response.

My view is that the trades do not always net out. While the macro traders are attracted to events such as subprime, china, commodities or Greece, value traders avoid those trades rather than taking the opposite view. Buffet did not invest in dotcoms for example. Each has his own reasons, from only trading what he understands, to seeking or avoiding volume/volatility, to seeking catalysts.

Aside from trades, there might also be a timing mismatch. Traders with most skill in my view know when to sit on their hands. Others might be lucky or unlucky. Eg penny stock momentum strategies might only work in the dotcom era but not after. On the other hand, value did well in the great moderation of 2004-2006 but not during the quant meltdown of 2007. Given the tendancy to chase performance, the dollars in each camp may not net out exactly.

 I hope this clarifies my view, but I do think there are top feeders that make good returns off their franchise. ETF providers make money both by providing access to hot markets and by lending stock to short, for example.

Call me Jordan…


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