The Other Side of the Trade

Whenever you enter a trade, there is somebody who wants to take the other side.  People forget that for every buyer there is a seller.  And it matters what type of person is on the other side. 

Let’s say you sell short a blue chip tech stock like AAPL.  Who is on the other side?  Most likely the person on the other side of the trade is an institutional investor, because for such a huge stock like AAPL, most of the end user volume is coming from funds managers or investment banks.   Sure you have the HFTs skimming profits, but they aren’t a long term factor. 

Now let’s say you short a low float, small cap stock that is up 100% on PR hype, or even a chat room pump.  There are so many of these kinds of stocks that I won’t even mention the name.  Basically your typical pump and dump play.  Who is on the other side of that trade?   Probably retail investors.  There may be a few hedge funds and quant shops that specialize in short term trading on the other side,  but the majority of the volume will be retail.  

Who do you want on the other side of your trade?  Institutions are far from being great investors, but they are much better informed than retail investors.  Retail investors make a lot of mistakes, which become magnified when trading volatile stocks.  Here is a list of some of the most common retail mistakes:

1.  Chasing the latest hot stock, buying into a PR or chat room pump believing the hype.  
2.  Minimal knowledge of fundamentals, don’t read or understand the SEC filings.  
3.  Looking for fast, quick gains, playing on much shorter time frames.
4.  A good trade is  a trade.  A bad trade becomes an investment.  Holding on to losers and becoming bagholders after the pump.  
5.  Poor at risk management.  Not cutting losers, liable to get margin calls and blow up.

Compare this to the most common institutional investor mistakes:

1.  Herd behavior and group think, but on a much longer time frame than retail investors, which makes it tough to fade.
2.  Can’t take excess downside volatility, due to client/bank demands.  Often stop out of positions when they go against them, even if fundamentals of stock haven’t changed.

Retail investor mistakes are much more common and more fatal when they happen.  Trading is about taking advantage of opportunities.  Opportunity comes when the other side makes a mistake.   That is why its easier to make money trading small caps than big caps.   And definitely much easier than trading macro like stock indexes, bonds, and FX. 

In macro, its dominated by the institutions.  That is why its much harder to beat that game.  The biggest advantage of trading futures vs small cap stocks  is leverage.   The next biggest advantage is liquidity.  You can trade more size and get in and out much more easily without moving the price.

When retail investor numbers are low, like they were from 2008 to 2016, then its better to trade futures.  But when retail investor numbers are high, like it is right now, its better to trade small cap stocks.  

We made an all time high yesterday and quickly sold off intraday, and gapping up strongly again today.   I sold longs on Monday and have been on the sidelines, mainly focused on individual stocks.  I don't expect to do much unless we get a big move either way from current levels, either an overextension move higher towards SPX 3800, or a dip down to SPX 3620.