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Tim Melvin on Ecology:
Trading strategies that worked since the dawn of time stopped working. As capital in extraordinary amounts chase whatever worked last year, the strategy was doomed. We've seen it in the last 5 years in risk arb where returns went from a steady, almost clockwork double digits to sub 5 for any serious amount of money.
In distressed securities the amount of new money literally forced the larger more established players to invent new ways of capturing the returns at the expense of the newbies and except for an exalted few, the likes of Tepper and Ross come to mind, returns went away. I think we will now see this with stat arb, pairs and statistical pattern trading.
For a predator to feast there must be prey. If all the game has been hunted and the plain is full of lions, tigers and cheetahs with all the wildebeest and gazelles eaten of vanished, then all but the largest, quickest and strongest predators shall starve. If our trading style takes advantage of other peoples mistakes...as risk arb, distressed, pairs, gap trading etc do...if they start playing the same game we are, there is no game anymore and the excess returns vanish. One must be aware of the ever-present switches the chair constantly warns us about lest we look up one day and find we stayed too long and only lions are left on the plain....looking at us hungrily.
Alex Park Comments
On a similar ecological theme, I have noted the feeding patterns of the local bird population in my garden. When I place food on the lawn, an observant bird may notice and swoop down to feed. However, other birds in the trees will eventually spot the lucky bird that has much food to itself, and they too will join in. This increases the size of the flock on the ground and hence its visibility to others. Eventually, what began as a plentiful meal for one becomes a tussle for crumbs which hardly pays for the energy involved in flying down to the lawn in the first place.
I imagine markets operate in a similar manner. Speculator A recognises a new way to make a gain. Initially he has the ‘pie’ all to himself. But his gains attract attention and soon Speculators B, C and D replicate his ideas and the gains are less attractive. Finally, gains turn into losses by the time Speculator Z is involved.
I wondered if there was a comparable idea in evolution. Imagine a new ‘chemical spray – Toxin A’ designed to prevent the spread of malaria by killing the vector i.e. Anopheles mosquito. Initially, the spray will kill, say, 95% of the mosquito population as they aren’t resistant to toxin A. Hence, initially there is a very strong selection pressure for toxin A resistant mosquitoes – that is, those that can survive can expect a huge fitness payoff as their genes will make up a large part of the next generation (as most of the competition are now dead). The subsequent generation, however, will be at least partially resistant and so one can expect more than 5% to survive and, therefore, the selection pressure is not as strong. Eventually, the population may show total resistance to toxin A and the selection pressure to be resistant to toxin A will have vanished. Again, the theme of the greatest rewards to those that are first to take advantage of a regime shift. Latecomers face a dwindling return.