Trading, investing and edge

As I have written in my previous post about focus in investing I do not see big differences between trading and investing. Trader and investor operate on different time scales but both of them are often managed by same financial laws. And first of that laws is Law of Edge.

It helps me to see trading / investing as a business. Imagine yourself as a owner of small store in suburb. You buy stuff, store it and sell to your customers. Your gains comes mosty from differences between price of goods you bought and price customers pay to you. You are making arbitrage profit. Customers could go to same wholesale store and buy stuff for same price as you do. But they do not want to buy in big quantities. They do not have enough room to store all of the stuff. You are making service to them and are paid for that service. You face risk that you will not sell all of that stuff in your store for such a high prices if anything happen to them. And you are also paid for that risk.

Now imagine that we are traders trading some stock on NYSE. We buy because some technical indicator showed us to buy and sell because it showed us to sell. We do this over and over and over. And we expect to make a profit. Why? What is an economic driver behind that profit? Did we engaged in some kind of arbitrage or did we just played?

Owner of the store knows his customers. He knows they have to drink, they are lazy and they will come to buy that bottle of Coca Cola from him even if it is little more expensive then bottle in store which is more distant from suburb. He back-tested it, knows how many spare bottles of Coca Cola should he has in store and not run into risk of not selling them. He knows how to price them. He knows ice cream is more popular in summer then in winter and is prepared for it.

This is the lecture I took from store owner. I have to know what my edge is. It doesnt have to be complex but it must be quantificable. It must be economicaly sound. I must know who the customer is. And I must know risks that I face when I am in position.

And this applies to traders and also to investors. Investors buy corporate bond and this way lend money to corporation. They expect to be paid. And they know from history how big that pay usually is and how big risks they face. They know their edge and know how big payoff they could expect. Traders who trade for example pair trading strategy know what risks they face and how big is their edge - how big payoff they could expect. This is why I look on trading, investing and business as a very similar human activities. It helps to transfer knowledge from one activity to another and find ideas on places where I sometimes expect them the least.