What role do traders have in the market?

I got into a bit of a heated thread over at Babypips, regarding the role that traders play in the market.

 

There's a school of thought that traders and speculators serve no useful function since trading is a zero-sum activity and thus no wealth is actually being generated. This is somewhat misleading. If there are ONLY traders within a market, then yes, I believe it is a zero-sum activity and any wealth generation is arguable.

 

Of course, traders are not the only players in the market. We have corporations who participate in the market for operational reasons, whether it be to raise cash via an IPO, hedge their risk, or supply the market. We have mutual and retirement funds seeking long-term investments. We have debtors liquidating assets to balance their sheets. We have governments and central banks pulling fiscal and monetary levers to direct the economy.

 

Bearing this in mind, I believe the trader serves three useful functions in the market:

 

1) We increase liquidity. An illiquid market means higher transaction costs and longer times for orders to fill. By adding our liquidity, we decrease both and ensure a smoother, quicker and efficient market.

 

2) We provide risk management for risk-averse companies. It may be tedious, if not dangerous, for a company to see fluctuations in the price of raw materials or currencies. To hedge this risk, a company may lock in a futures contract, guaranteeing a stable price for the foreseeable future. Traders serve as a counter-party towards this hedge. Without traders, there may be no counter-parties, and thus no hedge, and companies will be disadvantaged.

 

3) We bring the market closer to equilibrium. Without our input, markets may be manipulated or distorted beyond reason. Our goal, as speculators, is to define what we consider "fair value" and bring the market towards this level. If we believe something is cheap, we buy. If it's too expensive, we short. We exit when price is at "fair value", having completed our duty in punishing any unwarranted hysteria or panic.

The future: managing my own money, or other people's money?

I spent the last week having a good think about my future's direction. As a professional trader, I have two options:

 

1) Manage my own money

 

2) Manage other people's money

 

I've been reading CASHFLOW Quadrant from the Rich Dad Poor Dad series, and according to Robert Kiyosaki, most wealthy people obtain their wealth by utilising other people's money (OPM) and time (OTM).

 

If you're a professional trader / investor with a solid track record of profitability and low drawdown, investors will throw money at you. If you do decide to manage other people's money, your main source of income will come from fees. An advantage of managing OPM is scalability. There's not much difference in effort when investing $1m or $100m. Your investment or trading system(s) should be very similar in both cases. However, in the latter case, your income increases a hundred fold. Not bad at all. If you're a profitable trader using your own money, why not charge investors a fee to piggy-back on your success?

 

On the surface, this looks like an attractive proposition. But here are my reservations:

 

1) It becomes almost like a job. You're no longer answerable to yourself, but also to your investors. You'll be required to meet all sorts of regulations, expectations and KPIs. Most traders become so because of the freedom, and this sets you back in the corporate world, albeit you are your own boss.

 

2) Your psychological profile may mismatch with investors. Now, this can be partly remedied by being selective about those who invest with you. Most passive investors seek steady and reliable returns. In contrast, most traders want to strike it rich and retire as early as possible. Different goals. Many investors will balk at the prospect of losing 10-20% equity in a short-term drawdown, but traders know that such drawdowns are expected during long-term wealth creation.

 

There's prestige in finding your own hedge fund. Pyschologically, though, I don't think it's for me.

Recommended resources (Dec 2012)

Over the last year I've gathered a few sites / resources that I've found to be very useful. Some of my recommendations:

 

BabyPips

 

For anyone new to trading, I recommend BabyPip's "School of Pipsology". It's a FREE online course on basic trading. I've read a few introductory forex / trading books from bookshops, and found the School of Pipsology superior. The online community at BabyPips are also generally helpful.

 

Mercenary Trader

 

Mercenary Trader covers trading in general, not just forex. It's main emphasis, in my opinion, is on trader psychology. Mercenary Trader routinely releases newsletters that I've found inspirational and insightful. I tend to ignore the market commentary, although that is available as well.

 

Mechanical Forex

 

The owner of this blog / website, Daniel Fernandez, is a pure mechanical and automated trader. I'm a mechanical trader myself, and would like to become automated in the future. The site provides a free e-book which I can currently perusing. There's a noticable absence of quality information regarding automated mechanical trading. This site is one of those rare gems of expert knowledge that you'll find once in awhile.

 

Trading Heroes

 

I enjoy this website because I find the webmaster, Hugh Kimura, refreshingly honest and down-to-earth. I also believe that we're both at a similar level of development. The site doesn't contain much, strategy-wise, but it's most useful resources are the podcasts and interviews with professional traders. Getting an insight into the world of other traders is fascinating.

 

Pepperstone

 

My forex broker. I used to be with GoMarkets but found the spreads on Pepperstone to be much better. Many Australian traders seem to prefer Pepperstone. I've been with them for half a year and haven't encountered any critical problems so far.