11/29/2005
An Essential Book, by Victor Niederhoffer
The field of investments and speculation has now reached the point of all good sciences with the publication and diffusion of the great and essential investment book Trading and Exchanges: Market Microstructure for Practitioners by Larry Harris. Along with Dimson, Marsh and Staunton's The Triumph of the Optimists, and perhaps a good book on valuation such as Aswath Damodaran's Investment Valuation, and a standard text on investments such as Sharpe, Alexander and Bailey's Investments, market participants now have available a foundation for practical and theoretical knowledge in this field that is equivalent to what they might expect in any of the other sciences such as biology, chemistry, engineering or physics.
Kuhn in The Structure of Scientific Revolutions discusses this halcyon state that every science must achieve, and points out that it leads to a rapid accretion of knowledge as investigators extend the accepted knowledge in many directions, fine-tune the theorems, and test and sharpen the hypotheses that form the basis. And what a horn of plenty Trading and Exchanges provides. Each chapter set my head reeling, giving me theoretical and practical insights, suggesting areas I must study to improve my game, and sparking research in related areas that could lead to greater profits.
The book is about how markets work from the bottom up, with emphasis on:
There are 29 chapters in the book, each divided into a series of economic principles that provide a foundation for understanding the chapter: a series of stories about how the big boys and little boys profit and lose, the evolution of practical market solutions to facilitate the activity, and legal and efficiency issues that arise from the fray. I found in reading the stories after the economic principles that my whole trading life came back to me with deep resonances and overtones. I kept saying such things as "my goodness, if only I had known this, or hadn't let it happen to me!" or, "never again, the b##tards!"
Central to the book is the division of market participants into the following categories:
The book shows the impact of all the structures, rules, and trading procedures on each of those participants. A simple way to summarize one aspect of this division is that there are informed traders who know what they are doing and are going to profit no matter what, and futile traders who think they know what they are doing but serve to provide money and energy to the informed traders that make the system work. I had a similar division into producers, dealers, consumers and recyclers in Education of a Speculator.
However you slice it, you want to be trading with the futile traders, especially when they get lucky and think they are smarter than they are. The extensions of this rule to markets with upward or downward drift provides one of the best frameworks for profit for the sapient market participant.
Not explicitly mentioned in the book is that chartists and trend followers are mainly futile traders and that the idea that they can overcome the zero-sum aspects of the trading game by somehow taking money from informed traders and dealers is a theoretical and practical implausibility. Regrettably for me, some major brokerages seem to have realized this recently and are closing down such departments. But, fortunately for the continuation of the market, many funds devoted to such futile methods and the mystical belief that the past will be similar to the future, especially after a drawdown, are still going strong. I was unsure whether to compliment the author on his diplomacy, or chide him for his naiveté in not covering this natural extension of his work.
My favorite chapters in the book revolve around the exact mechanics of orders. Orders are of two different types: market and limit. They differ in their uncertainty of fulfillment, and the liquidity they provide. In a essential passage, Harris states "Traders who use limit orders grant trading options to the markets because they allow other traders to trade when they want to." He goes on to show that limit orders in general will be slightly more profitable than market orders, because it takes more time and expense to move them as the situation changes than the simple market order which provides liquidity. A typical table in the book describes some fine points in the types of orders. Although I wrote one of the first technical articles on the properties of orders and their effect on prices on the exchange, and have followed the field closely as a practitioner continuously and actively for 40 years, I found there were numerous areas of which I was completely ignorant and many others that I had to learn about quickly in order to perhaps better prosper.
One of the strengths of the book is the frequent use of games and sports to illuminate the decisions that market players should and do make. All of us can relate to such things as to how proper strategies and tactics in card games, sports and bargaining can help us attain our goals. Through Harris's lens and the foundation of economic principles and actual market practices in each field, you learn how and why to apply these to win in markets. Some of my favorite passages:
A comparison of bookies to dealers:
Most sports betting markets are quote driven markets in which books are dealers. The bookies try to maintain a balanced book. When bookies have balanced books, their only risk is that their losing clients will not pay up. Dealers minimize their credit risks by carefully screening their clients. They limit the credit that they extend to cover their potential losses. Ruthless bookies also minimize their credit losses by threatening the kneecaps of their deadbeat clients.
Investors and borrowers:
People often need to move money from one point in time to another. People face intertemporal cash flow timing problems when their incomes and expenses do no coincide. When their incomes are more than their expenses, they invest, to move money into the future, or they repay money they have borrowed in the past. When their incomes are less than their expenses, they borrow or they liquidate investments. People invest, borrow, liquidate, and repay to move money forward or backward through time.
Block traders play Concentration well:
Block traders play a game similar to the card game Concentration in which players take turns uncovering cards and attempting to match them. To match buyers to sellers, block traders must remember who was, who is, and who would be interested in trading hundreds of securities.
Harris has many beautiful discussions of why past performance is not indicative of future success. His 2 by 2 table of skill versus outcome with the lucky and successful being insufferable is at once deeply explanatory and hilarious, as are a hundred other tables and classifications in this 643 page book. Perhaps the main weakness in the book is that Harris seems unfamiliar with the niches that profitable market participants must gravitate to if they hope to overcome all the frictional costs that the market structure imposes. The key reason that many apparent anomalies exist is that they are lures to foment hope in the uninformed. Whatever works in one field or another, or with one technique or another, the Law of Everchanging Cycles insures will not continue in the future. Similar farsightedness is seen in the chapters on bubbles, and performance evaluation, with a 10 page introduction to t-tests, statistical power, and distribution theory. But regrettably this material leads up to misleading conclusions about the Sage. The real question is whether the Sage's message and skills will hope up in the future, now that the tax losses and angles and constant bearish messages have used up their wind.
But one or two defects in a book with literally more than a thousand good parts is only human. Trading and Exchanges is essential reading for all market participants. Anyone who takes an investments class, or has been, is, or will be a market participant should read it. It belongs in every library, every home, every economist's and lawyer's office, and should be required reading in every investments and finance class. Finally, the elementary and structural part of investments, from which everything else builds, has its masterpiece.
