Laws of trading

In a previous post I briefly touched on the sheer amount of useless or outright bad information when it comes to trading, or even investing in general. There are also few exceptions to that, and one of them is the book “The Laws of Trading […]” by Agustin Lebron. I liked the math-free approach and focus on market psychology.

Coming from an undergraduate in Finance & Economics, I have seen enough of the pricing formulas, have knowledge of the financial institutions, and other market participants – at a theoretical level. What I was lacking was a grounding in market psychology, and this book provided that.

A rough break down of what stuck with me after going through it is:

1. Motivation Link to heading

The essence of this chapter is to remind the reader that trading involves a lot of self-knowledge. Do not trade emotionally, and know beforehand what the reason for trading is. In other words trade with a plan, not out of fomo, greed, or fear. The other key point is to trade only if you have an edge.

2. Adverse Selection Link to heading

Trading can be viewed as a form of information exchange. When engaging in a trade, it is best to assume the counterparty is well-informed, and thus one should be willing to update their beliefs based on new information arrival, aka Bayesian approach to statistics.

Information asymmetry and adverse selection underpin the market. It does not matter how skilled a trader is, if the counterparty has access to more, or all, relevant information, then you will lose the trade more times than not.

3. Risk Link to heading

Risk is the name of the game. Do not focus on only one particularly risk metric but gain a comprehensive understanding of all the risks of the trade and/or portfolio.

4. Liquidity Link to heading

Liquidity is a proxy of how hard, or easy, it is to exit a position. Acquiring deep knowledge of the traded market will help when transacting more cheaply, safely, and efficiently, due to more knowledge on the liquidity levels (“anchors”), bid-ask spread, market impact, etc.

5. Edge Link to heading

Trading with an edge is the single most important aspect of trading. Statistically, trading with an edge is the only way to not be wiped out and be profitable in the long-term. There is not one universal definition of edge, as it is very elusive, like the concept of “alpha”, but the best one seems to be:

something you know or can do that others don’t or can’t do

More informally that would be called “the moat”.