During a finance lecture, my professor told a class of 120, “Markets are usually fair and reflect true value of an asset and market have a tendency of correcting the over pricing or underpricing over a period of time. The traders however, hope this time lag is large enough that they can make risk free money”. At that point of time the information was merely an observation of a person who theorized the markets and had little or no exposure to actual trading. Over a period of time, after studying the markets closely, I wondered – unless you are Berkshire Hathaway with a knack of identifying potential value stocks and making money over short terms, could a day trader make real money without manipulating the market? (Real money in trading is half a million dollars or more daily) Is it really possible for traders or hedge funds to bet on market fluctuations with reasonable accuracy to make a real net profit? Can any trader hedge large sums of assets, large enough to make real money if she/he knew the outcome was dicey? These are few issues are would like to talk about. Although I am not equipped with data to make a call one way or the other, I could present a case and let the readers make their own judgment.
The logic behind market correcting itself can be seen in the following case study.
The value of an asset can be term in two ways,
1. Intrinsic value – value of the asset determined by its future cash flows discounted to present value
2. Perceived value – market sentiments and overall performance of the sector that rubs off on the asset thereby adding value to it.
The market value of any asset is a function of the above two values. The trade volumes are mostly determined by the perceived value but the initial investment happens only because of the intrinsic value. The gap between the two is the scope for the trader to make money. The moment the intrinsic value catches up to the perceived value, the undue profit on the trade halts. The notion that markets corrects itself is based on the assumption that its takes a short while (from few hours to a day) for the intrinsic value to catch up the perceived value as the undue demand for the stock pushes its price upwards till the two values match and then stabilizes and trades between a narrow margin.
The trader can make risk free profit if she/he can delay this upward surge of stock price by either getting illegal information (insider trading) or by artificially creating a downward trend to delay the surge. In each case, the trader has to use unethical/illegal practice to manage this and make millions by using this window effectively. Left to it, the stock surges up or down to meet its perceived value and it takes on in a million chances to utilize this natural window. However, this window can be artificially created by traders too. Imagine a company has decided to diversify its business and it knows that once the decision is made public; the stock prices will shoot up by 10% its present value. If a trader gets this information before the press release- she/she could buy these stocks at present value and then make instant profit of 10% or more my selling it once the press release is made and information becomes public. This is risk free return and is hence illegal because it comes at the cost of other honest investors who get a lower return. Similarly, traders are known to collaborate with other traders to simultaneously off load large stock of shares to artificially and temporarily lower the price of a share. The window is then used to buy back the same stocks at a lower rate and make risk free profit at the cost of other investors. This usually works best for currency traders.
I cannot however think of any other way a trader can make real money by trading within the realms of ethical trading practices. I may be wrong, there could be a case where traders actually make good calls consistently and work within the natural window of a stock and make real money. I would however like to know a few of them to correct my perception. Until then….
So long..
The logic behind market correcting itself can be seen in the following case study.
The value of an asset can be term in two ways,
1. Intrinsic value – value of the asset determined by its future cash flows discounted to present value
2. Perceived value – market sentiments and overall performance of the sector that rubs off on the asset thereby adding value to it.
The market value of any asset is a function of the above two values. The trade volumes are mostly determined by the perceived value but the initial investment happens only because of the intrinsic value. The gap between the two is the scope for the trader to make money. The moment the intrinsic value catches up to the perceived value, the undue profit on the trade halts. The notion that markets corrects itself is based on the assumption that its takes a short while (from few hours to a day) for the intrinsic value to catch up the perceived value as the undue demand for the stock pushes its price upwards till the two values match and then stabilizes and trades between a narrow margin.
The trader can make risk free profit if she/he can delay this upward surge of stock price by either getting illegal information (insider trading) or by artificially creating a downward trend to delay the surge. In each case, the trader has to use unethical/illegal practice to manage this and make millions by using this window effectively. Left to it, the stock surges up or down to meet its perceived value and it takes on in a million chances to utilize this natural window. However, this window can be artificially created by traders too. Imagine a company has decided to diversify its business and it knows that once the decision is made public; the stock prices will shoot up by 10% its present value. If a trader gets this information before the press release- she/she could buy these stocks at present value and then make instant profit of 10% or more my selling it once the press release is made and information becomes public. This is risk free return and is hence illegal because it comes at the cost of other honest investors who get a lower return. Similarly, traders are known to collaborate with other traders to simultaneously off load large stock of shares to artificially and temporarily lower the price of a share. The window is then used to buy back the same stocks at a lower rate and make risk free profit at the cost of other investors. This usually works best for currency traders.
I cannot however think of any other way a trader can make real money by trading within the realms of ethical trading practices. I may be wrong, there could be a case where traders actually make good calls consistently and work within the natural window of a stock and make real money. I would however like to know a few of them to correct my perception. Until then….
So long..
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