I’m a professional stock trader. Here are some common tools of our trade.
WARNING: This is long. If you want a post that’s short or cute, this is not for you.
Most important are the things you wouldn't expect.
Risk management - Great traders keep their resources allocated to the best opportunities, all the time. They don't get emotional about losers, they cut them. They don't get too excited and cover winners early, they hold them until the trade is done. They step on the gas in good times and play smart in tough times for their strategies.
Timing - Ordinary investors get caught up in the hype and buy high, then panic out and sell low. Great stock operators have better timing because they buy and sell based on considered strategies with defined entry and exit parameters.
Execution - Implement the arbitrage strategy faster. Work through bids and offers efficiently to reduce slippage. Gather and interpret all that special data with super-fast computer systems. And you'll get better entries, reduced losses, more shares out at the best prices -- overall, a more precise implementation of your strategy.
Layering - Imagine you’re a great value investor, and then you layer other advantages on top. You sell a lot of insurance and use it to provide low-cost leverage and tax benefits. You're big enough that you can negotiate deals at huge discounts to buy stock from giant corporations, or to get cheap financing. These are the lesser-known elements of Warren Buffett's success.
Asymmetric Returns - Almost no successful stock traders make precise predictions of where stocks are headed, or have the kind of pat explanations of market behavior that television pundits immediately, constantly, and comprehensively give us. Rather, what they do is get into positions that will sometimes win and sometimes lose, but the wins will be much bigger than the losses overall.
Give To Get - The market is a conversation. If you’re not contributing much to the conversation, don’t expect to get anything extra out of it. You might contribute new information, or make it easier for investors to move money easily at a good price. You might smooth out some inefficiencies that crop up, or lessen the blow of boom-bust cycles. For all but maybe three of the strategies below, traders’ profits are compensation for their contributions to the market.
Okay, now on to some strategies!
Activist Investing - You uncover massive fraud in a company, place a bet against its stock, then alert the public. Alternatively, you see a massive opportunity that a company isn't taking advantage of, buy enough of the company to make it do what you think it should, and profit when your changes work.
Event-Driven - Expert in special events. A company splits into two stocks and you're the only one who knows one is worth twice as much as the other while everyone else thinks it's even. Buy low, sell high, then publish the truth and make 30% in a few days.
Distressed - People dump the stocks of companies going bankrupt. If you know what you're looking for, you can get deep discounts on assets, or you can negotiate deals that give the company better prices in bankruptcy.
Long/Short Equity - The vanilla hedge fund strategy. Pick the best and worst companies, buy the best, and sell the worst. Usually the reasons you hear on television: this company has the best strategy, that one has weak financials, the other industry is weak. Standard version, 130% of fund value bets on the market to go up while 30% bets on the market to go down, which means you're using a bit of borrowed money. Mix in some derivatives to hedge risk.
Funds of Funds - Maybe you're no good at beating the market yourself, but you're good at picking which managers will. Build a portfolio of great managers.
Macro - You have a picture of where the world is going and place bets on it. Gold is undervalued and primed for a pop. The British Pound is about to break through massive resistance. Money will rotate out of tech and into materials.
Value - Buy good companies for cheap, and hold them for a long time. Commonly you're looking for great financial statements: hardy assets, minimal liabilities, robust earnings.
Growth - Buy companies that are set to explode. Build a portfolio so that the small losses you see in those that don't work will be offset by the huge wins you see in those that do.
Momentum - Stocks that are already going up tend to keep going up. Now, when they fall, they fall really hard. But historically, the expected value versus the market has been positive.
Trend Following - When a market or sector is trending, get in stocks that have already formed trends and add in until they stop following their trends. Ideally you buy when a stock is in consolidation or correction within the trend.
Technical Analysis - Looks at price action. There are lots of variants here, from standard Moving Averages to Elliott Wave and Darvas Boxes. Don't buy into the black magic versions, but most traders I know pay attention to, say, the 200-day moving average, which basically tells you how a stock has generally trended over the last year.
Mean Reversion - The opposite of Trend Following. Profits when a stock has moved too far too fast, and it bets against the move. If a stock is massively overextended it's a mean reversion candidate.
Breakouts - Stocks can hit thresholds of resistance where there is concentrated buying or selling pressure. When they pop through those buyers/sellers, often there is a lot of room for them to run. Identify those key points and when stocks will break them.
Market-Making - Say that a stock is "really" worth $50/sh. If you want to buy or sell, you've got to buy or sell from someone. A market-maker buys or sells for a slight premium versus his model of the "real" value of a stock -- say, $49.95 or $50.05 for a $50.00 stock -- which takes the hassle out of finding a buyer or seller at exactly your price.
Arbitrage - If Gold were trading in Chicago at $40/oz and in New York at $50/oz, you would buy all you could at $40 and sell it at $50, as fast as you could. That's arbitrage. Today such opportunities still exist when we cross different markets and exchanges, though they're typically rare and small. There's also opportunity for those who have great pricing models for sophisticated derivatives, or things like credit spreads.
Exchange Rules - There is a complex ecosystem of rules among venues for stock trading (arca, nsdq, bats, edgx, iex, etc.). In some circumstances you get a rebate, in others you pay a fee. If you can navigate this deftly but others can't, you may be able to pick up the difference between rebate and fee.
Undeveloped Markets - Any market without capable eyes on it will have lots of inefficiency. Arbitrage, trending, massively overextended moves, and so on. Bitcoin was free money for market-makers early on. This could be obscure derivatives, young foreign stock markets, whatever.
Early Information - You send an analyst to a courtroom so that you know the results of an important case first. You post people at gas stations to count the trucks coming out of a warehouse, so you can estimate the change in sales before anyone else. You use satellite imagery to model construction patterns across the globe.
Regulations - Ordinarily companies release big-time information quarterly and annually. Sometimes they are forced to reveal that information early due to obscure regulations. If you know which random agency or tiny country they report to early, you can trade on the information before the rest of the market.
Quantitative - Typically these guys use ordinary strategies, but they do it with computers. So they do market-making with massive statistical models, or their computers read news headlines, or they learn about a company's fundamentals from its customers on social media, or their intricate derivatives formulas spit out easy numbers in an instant.
Market Player Constraints - Lots of big players have somewhat arbitrary rules, such as constraints placed on pension managers or mutual funds. Whole classes of investment dollars sell out when stocks fall below $5 or $1. Tax-loss harvesting at the end of the year from robo-advisors. Stocks that have just gone to the pink sheets, or just declared bankruptcy.
Market Player Behavior - By knowing other strategies' behavior, you can anticipate moves. You watch for that bump when a stock falls into the parameters of value players, growth players, momentum players. You model when a stock will be added to this or that index and/or ETF.
Access - Maybe you have an IPO pipeline due to relationships at major banks. Since IPOs are intentionally priced to climb 10% or so in the short term, you can flip them easily. Or maybe you're the only player with serious access to a particular market (ability to use computerized systems, ability to place lots of orders, ability to sell short), so that you can do big boy market-making with no competition.
Work For Congress - Lawmakers have hugely significant inside information about the treatment of industries and even particular companies... and it's legal for them to trade on it! Supposedly very few of them successfully parlay this informational advantage into meaningful profits. Michael Hayter helpfully pointed out in the comments that this was the subject of recent legislation, and what I wrote in this paragraph is outdated.
Other People’s Money - It’s really easy to come up with a strategy that pays off most of the time, so long as you’re willing to lose it all once every few years. The compensation structures with certain banks, funds, and government relationships allow you to profit massively during the good times and pass off all the losses onto someone else.
Disclaimer: This is information, not recommendation. These strategies have been successful for people who are really good at them. All of them are likely to blow up in your face if you’re not really good at them… and possibly even then.
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