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Jul/23/2008
Stock Trading is Debating

What sets us humans apart from the rest of the Animal Kingdom is not the brain in itself, but our ability to connect our minds. Our desire to communicate, and the creativity in finding better ways of doing it, is by far so overwhelming you should stop reading now and reflect for a minute.

This text will, as most articles on this site, discuss the market. But only the last two paragraphs offer new insight, while the rest of the reading is meant to recall the intuition of the role of the market.

Trading is obviously impossible without communication. Imagine a plausible situation in the origin of mankind. A person has been picking berries all day. Another one has had a good day catching fish. They meet. Three scenarios can occur. One, they ignore one another. Two, they fight. Three, they exchange goods. Option one is unlikely the best one, no matter what perspective you have. Option two will, for the superior one, be the best if the cost of fighting is smaller than the gain from stealing the good. Option three is with little doubt the best choice, for the inferior one of course. But also mankind would gain. The inferior will use less effort in hiding, fewer injuries from conflicts would benefit other members of the tribe and even the superior may benefit as the inferior one would perhaps not pick berries at all if he fears being robbed.

So far trading was no more than using communication for the mutual benefit of exchanging goods. Instead, if we had several berry pickers, the fisherman would want to talk to them all and trade with the one who offers the best beery-to-fish ratio. Say now that there are two berry pickers, where one of them always meets the fisherman as he comes ashore with the day's catch. The other one expects the fisherman to meet him somewhere deep in the forest. The fisherman would of course select the one at the shore unless he is offered a sufficiently better exchange rate deep in the forest. Most likely the two berry pickers would find that the one the closest to the fisherman would get the deal, so that they both would meet him ashore. However, they could (and should for their own sakes) cooperate and act as one bargainer and share the profit, rather than competing against one another. But this is not the essence, the bottom line is that one location for trade will develop, and as more fishermen and berry pickers appear, they will all be individually the best off if they go to this particular location.

What we now have is a market place. No matter how many fishermen and berry pickers, everyone will deal with the same exchange ratio. Without a market place, all fishermen would have to talk to several berry pickers and vice versa. This would have taken a lot of time and indeed be costly, so that arbitrageurs or brokers would have been a new occupation helping to reduce the problem. And this problem has never been solved until today, as electronic trading has the potential of making brokers (in the traditional sense) superfluous.

Another problem (which with a trustworthy party can be solved) occurs as the number of goods is more than two. With berry and fish, the only price you have to deal with is the berry-to-fish ratio. If someone wants to sell for instance sheep, two new ratios appear; sheep-to-fish and sheep-to-berry. Still no problem, but as more and more goods are traded the number of prices get tremendously huge and impossible to keep track of (with n goods: n(n-1)/2 prices.) As you guessed, the solution is money. Now the number of prices is the same as the number of goods (with n goods: n prices.)

Today the goods you can trade sometimes go into the abstractions and the understanding of what is going on is often far into the land of ignorance. The previous paragraphs were written to recall the easy-to-forget intuition of market exchange. I want you to ask yourself: What do I really trade when I trade shares in a company? Financial theory falsely assumes that all the upcoming dividends of the company set the price. This would only have been the case if you buy and never will sell (ala Warren Buffet perhaps.) Another possibility for trading is that you believe your estimation of the probability (and/or payoff) of some outcome is better than what the market believes. Here are perhaps sports gambling and bet exchanges better alternatives. Another reason to trade is the urge for risk, but here casinos may fulfill your desires better (perhaps with the exception of some hot daytrading stocks.)

The primary reason for trading individual stocks is, I think, the same as the reason why people argue, discuss and enjoy debating. Discussing with one person is easily done with words. You say something, be it verbally or in combination with body language, where your choice of words depend on what has been said and what reply you expect to get in return given your choice. What is important never to forget though, is that the winner of a discussion is not necessarily the most correct one about what is being discussed. I should perhaps go no further than calling it a mysterious social game. Is trading a stock really that different? You express yourself in a totally different way of course, but being either long or short is a game where you choose the side you believe other will choose after you. Fundamental info is only occasionally the reasons for why people may choose the same as you chose before them. Trading and discussing are indeed the same; it's all about agreeing ant the winner is the one who does not have to change mind.



A compliment from 'HowTheMarketWorks.com'
Great article guys! It's rare that we step back and take a philosophical look at our trading behaviors.

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