Book Review: Trading and Electronic Markets
Conventional wisdom holds that beating the market requires finding undervalued securities through fundamental analysis. Textbooks tend to focus on the tools for determining a security’s value. They address only briefly the different types of transactions that can be executed in the market, with little to no discussion of the nuances of trading. Although trading is one of the important aspects of investment management, the academic training that prospective traders receive covers only its most basic aspects. The trading process involves many intricacies that investment managers must understand in order to succeed.
In Trading and Electronic Markets: What Investment Professionals Need to Know, Larry Harris, CFA, the Fred V. Keenan Chair in Finance at the University of Southern California’s Marshall School of Business, attempts to fill this void with the knowledge that traders need to compete in the financial markets. The book runs a mere 79 pages, and the wise reader will take the time to digest the material thoroughly. Even those with some knowledge of trading may need to read it more than once to grasp the insights fully.
Harris begins by discussing two concepts that are essential to successful trading — why people trade and the fact that trading is a zero-sum game.
Although the question of why people trade may seem trivial, Harris warns readers not to neglect this important chapter because in many cases, investment managers’ mistakes result from a failure to understand why they or other market participants are trading. Harris points out that trading’s zero-sum nature means that profitable traders extract their gains from other traders. Understanding other market participants’ motives allows traders to determine the most opportune time to trade.
In most fields, understanding the opposition’s motives is imperative to making optimal decisions. World leaders would not consider a policy toward another country without considering its motives. Similarly, a poker player considers the other players at the table before deciding how much to bet. Yet, traders often engage in trades worth millions of dollars without understanding the motives of the person on the other side of the transaction.
Many market participants would be surprised to learn that some traders’ primary motive for trading does not relate to profit. Harris points out, however, that utilitarian traders use the markets to obtain such benefits as moving money from the present to the future or hedging risks without regard for profit.
Harris then highlights two essential facts about profit-motivated traders. First, they will trade only if they expect to earn a profit. Second, profit-motivated traders cannot profit in aggregate if they trade only with one another. Therefore, they must trade with utilitarian traders who are willing to lose to them.
Understanding when and with whom to trade are critical to a profit-motivated trader’s success. For example, buy-side traders need to understand their portfolio manager’s motives. When trading on information that others will know in the future, a trader must trade aggressively before the price moves. When trades are not based on information, however, traders can be patient and wait for the market to come to them.
Harris divides profit-motivated traders into several categories. Informed traders examine fundamental value and/or estimate changes in fundamental value, and Harris differentiates value traders from news traders. Parasitic traders include those who speculate on future prices based on information they obtain about future trades, and he breaks down this category into front runners, quote matchers, sentiment-oriented technical traders, and market manipulators. Finally, Harris discusses liquidity suppliers, a category that includes dealers and arbitrageurs.
Transaction costs play an important role in trading, and Harris discusses both measuring and managing these costs. Estimating explicit trading costs, such as commissions and the cost of employing buy-side traders, is straightforward. In contrast, estimating implicit transaction costs, which result from the market impact of trading, can be difficult. Harris details the approaches to measuring implicit transaction costs and the difficulties that can arise in estimating them.
The longest chapter, which is on electronic trading, spans more than a quarter of the book. Electronic trading markets provide efficiency and speed and have spawned a new breed of traders. Such varieties as high-frequency traders and low-latency traders can exist only in electronic markets because they depend on engaging in high-speed transactions.
The growth of electronic markets has given rise to a host of regulatory issues. Harris discussed these issues and follows up with an appendix on the 6 May 2010 “Flash Crash” to illustrate some of electronic markets’ pitfalls. Traders need to understand the types of transactions that are detrimental to trading in these markets, and regulators need to institute safeguards to prevent similar crashes.
Trading and Electronic Markets: What Investment Professionals Need to Know fills a knowledge gap for students and early-career practitioners to better understand a key aspect of financial market participation. Gaining an edge in investing goes beyond solid fundamental analysis and requires participants to understand why they and others trade.
Harris’s concise writing style and numerous examples make the most difficult concepts approachable. The book is valuable not only for prospective traders but also for portfolio managers, who depend on traders to implement their strategies. A key takeaway is that portfolio managers are likely to achieve better results if they share their intent with their traders, enabling them to carry out the desired transactions in the most advantageous manner. Although the subject matter is difficult, readers who carefully study this small book will gain insight that will greatly benefit them and their firms.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.