How to Beat the Bots on Wall Street

By Jared Dillian, Mauldin Economics:

There was a point in my career at Lehman, when I was trading index arbitrage, where I pretty much knew that unless I figured out a way to trade algorithmically, I was going to be out of a job.

One, I wasn’t a programmer. Two, I didn’t even know where to start. And three, I doubted Lehman would have put the resources behind it. So I was out of a job.

I was also a floor trader. Those guys lost their jobs too.

There is a huge existential crisis on Wall Street now, especially in equities. Thousands have been laid off. Some guys are still hanging around for a couple of six-figure orders every month so they can make their mortgage payment, but the picture is exceedingly bleak. Usually a bull market means happy sales traders, but not anymore.

The credit guys are still doing well, but they will get what’s coming, someday.

What do you do if you’re a trader and you lose your job to a computer? You are not uniquely qualified to do anything in particular. Some people become insurance agents. Some people open restaurants. Some people work at restaurants.

The beneficiaries are the young kids, the computer science majors who program computers to trade ticker symbols about which they know nothing at all.

It’s a weird situation. The game of baseball has gotten more efficient, and the game of trading has gotten more efficient. It can be tempting to go up against the computers, head-to-head, like day traders do. Don’t do that. You will get your clock cleaned.

How to Beat the Bots

The one thing computers have yet to figure out in baseball is chemistry. Sometimes players get along, sometimes they don’t, but no computer will be able to quantify its contribution to the number of wins each season. The corrupt, lovable ’86 Mets got along famously. For the last few years, the Yankees have looked like they have as much chemistry as a university history department.

When it comes to stocks, you can’t beat the computers by trading faster (duh), but people try. In fact, having a holding period of anything less than a few days is just madness.

But computers are not clairvoyant. They can’t see the future, but in some cases, people can.

I’m not talking about what the Fed does, stuffing data naively into economy.xls. By 2006, it was obvious to much of the investing community that there was a housing bubble, yet it didn’t become apparent to the Fed (which is basically a computer) until the very end. Sometimes it’s just obvious. The coming Canada bust seems obvious to me. The BOC still sees a soft landing. Go figure. (I explain how to short Canada and how to invest in the US housing market in the last two issues of my investment letter, Bull’s Eye Investoryou should check it out.)

Whenever I talk to investors, I always tell them to stretch out their holding period, by months or years. Computers have made things efficient in the short term but have actually contributed to greater inefficiencies in the long term. Before computers, I used to worry about entry and exit points. Now I couldn’t care less. The value is in the idea and the risk management. The execution is worth diddly.

You should be thinking more, and doing less – which goes for just about everything nowadays. By Jared Dillian, Mauldin Economics

Wall Street is a special place, with a special piece of equipment, a sausage maker: US junk and derivatives go in. Plump, yen-denominated, highly rated bonds come out at the other end. Read… How Wall Street Is Exporting Toxic Junk Loan Waste To Japan

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  7 comments for “How to Beat the Bots on Wall Street

  1. hidflect
    Apr 18, 2015 at 9:44 pm

    Plenty of us saw the housing bubble. The problem is you can’t time the market. You can get trampled betting against the insanity of the herd running for the cliff. And plenty did. What computers can’t do is see the non-balance sheet. The innate values of companies. e.g. a firm that had lacklustre profits but held 3000 distribution network points all over S.E. Asia for example. I made a 50% gain in a day on ASX:TOLL (aus) when they got bought out by Japan Post. No computer would foresee that.

  2. Jungle Jim
    Apr 19, 2015 at 12:10 am

    There is a good deal of truth in what he says, but be very careful about the entry and exit point comments. If you are young and have a long investment horizon , it should work, but if you are not young, then the entry and exit points can be a serious matter.

  3. Paulo
    Apr 19, 2015 at 8:02 am

    This essay makes a lot of sense about trading by individuals. I always get a kick out of my friends who wisely talk about their investing inside knowledge not understanding that a rising tide floats all ships, even theirs, and they are merely along on the algo ride.

    As for the housing crisis (both US and Canada)….funny, my wife and I sold out in 2007 and relocated allowing us to substantially purchase more land in a better place to live. I know many others in this position. Funny, how this was in Canada. Funny also how Canada has balanced its budget this year as well. Certainly Toronto and Vancouver are due for a huge property crash due to the drying up of outside buyers (Chinese). The rest of us are doing and will do just fine when times get tough.

    Stats that are averaged screw the picture of what is really going on in Canada. Certainly, those in debt to purchase mega over-priced Vancouver and Toronto homes are way over in risk and acting very foolish. But if you get out in the rest of the country not everyone lives like that, preferring instead to function ‘long’, in a very conservative and steady way. My children are on this same path. Many will lose their homes and may have to forgo the morning lattes. The realators may have to get a job that actually produces something and regroup. Tough shit. Life never was a tv commercial, folks. Get real.

    • Mick
      Apr 19, 2015 at 4:34 pm

      I live in Canada too, and agree with most of your comments, but if you believe that Canada is ok cause Harper balanced the budget, I think you have some surprises coming.
      As for real estate, all cities but Van and TO are declining, so if you’re in another city thinking your property won’t decline cause it’s not in Van/TO, too late, it already is.

      Canada is done.

  4. Petunia
    Apr 19, 2015 at 1:17 pm

    I’m reminded of the movie “War Games” where the computer figures out that the only way to win is not to play. Having worked as technical support on Wall St. in fixed income I think “investors” should be very afraid. The disconnect between programmers and financial people is very real. I was both a CS and Economics major and was surprised how ignorant the programmers were about the financial aspects of what they were doing. And I also saw how technically deficient the traders were. When I saw the Knight Capital crash I knew immediately what it was. Get use to liquidity disappearing in a flash, to the traders it’s money, to the programmers it’s just data.

  5. Ivan
    Apr 20, 2015 at 8:32 am

    Day trading is like going to a gun fight with a knife. Don’t lose Granny’s 401K. Get another gig and move on.

  6. Julian the Apostate
    Apr 21, 2015 at 8:48 am

    There seems to be a technological divide between reality and virtual reality. The defining characteristic seems to be childhood experience with the Turing machines – while I took some computer classes the PC revolution had not yet occurred. While the Gen X crowd are computer literate, the Millenials absorb it with their Mother’s milk… I fall in the old paradigm with the buggy whip manufacturers. But a bad side effect of this sea change is that living in virtual reality takes a real toll on people skills and work ethics. Companies are hiring to the lowest common denominater and taking no chances that might land them in court. And reality doesn’t care about your feelings and will slap you around severely if you ignore its rules. We are fortunate to have a few contrarians who can translate across this divide, but not nearly enough.

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