In this chapter, Fei Si briefly introduces some basic conditions of the trading industry. Let us interpret it from five aspects.
1. The difference between trading and investing
"Investors buy for the long term, believing that their investments will appreciate over a considerable period of time (many years)," Faith wrote in his book.
“Traders only care about price; essentially, they are buying and selling risk”
These two sentences reveal the essential difference between investing and trading: investors buy the future, while traders buy risks.
Markets allow risk to be transferred from one participant to another, which is actually the reason why people create financial markets and is also a permanent function of financial markets.
Regarding the risk transfer effect, Feith gave an example of Southwest Airlines to further illustrate:
In order to balance oil prices, Southwest Airlines hedged in the oil market. When oil prices rose from $25 per barrel to $60 per barrel, the company's costs did not increase much. Even after years of rising oil prices, 85% of its fuel was still purchased at $26 per barrel.
It can be seen how necessary it is for a company like Southwest Airlines to use futures contracts to guard against operational risks.
But risks can only be transferred but will not disappear out of thin air. So why would the trader sell the futures contract to Southwest Airlines? Is the trader stupid?
2. Types of Risk
Feith divides risks into two types: liquidity risk and price risk.
a. Liquidity risk
“Liquidity risk is the risk of not being able to buy or sell: when you want to buy, no one is selling; or when you want to sell, no one is buying”
“Many, perhaps most, traders are short-term traders who are operating on what is known as liquidity risk.”
“Traders who take this liquidity risk are usually called scalpers or market makers, and their profits come from the bid-ask spread.”
“There is also a variation called arbitrage, which involves liquidity in two different markets.”
"An arbitrage trader might buy crude oil in London and sell it in New York, or buy a portfolio of stocks and sell a stock index futures representing a similar portfolio of stocks."
b. Price risk
“Price risk is the risk that prices will rise or fall significantly”
For example, a farmer may worry about rising oil prices because when oil prices rise, the cost of fertilizer and tractor fuel will increase. He may also worry that the price of wheat will fall too low and he will not make money. At this time, they need to hedge their risks.
“Hedges hedge price risk by transferring it to traders. Traders who take on this price risk are called speculators or position traders. Speculators make money from price changes: they buy and then sell when the price rises, or they sell and then buy back when the price falls – this transaction is called short selling.”
It can be seen that the ultimate risk bearers are traders, so why are traders willing to be the "suckers"?
3. Why do traders play risk games?
Feith divides traders in the market into three categories: hedgers, speculators and haters.
“Markets are made up of groups of traders buying and selling from each other”
"Some traders are short-term traders who just want to earn the difference between the bid and ask price over and over again; others are speculators who try to make money from price changes; and still others are risk-averse businesses. Each type of trader is a mix of good and bad, from experienced veterans to newbies."
It can be seen that the fundamental reason why traders are willing to take risks is to earn the difference profit from price increases or decreases. So why do prices change?
(Fun fact: In the past, the volume of a contract was determined by the capacity of a railway car: 5,000 bushels of grain, 112,000 pounds of sugar, 1,000 barrels of oil, etc. Therefore, contracts are sometimes called railway cars.)
4. Logic of price changes
“Price changes depend on the collective attitude of all buyers and sellers in the market. When the collective attitude changes, prices will change.”
“For whatever reason, once sellers are no longer willing to sell at the current price and want to raise the price; and buyers are willing to accept this higher price, the market price will rise. Similarly, for whatever reason, once buyers are no longer willing to accept the current price and want to lower the price; and sellers are willing to sell at this lower price, the market price will fall.”
Simply put, the reason for price changes is human nature.
5. The times are changing, but the essence of finance remains unchanged
“Remember that when I refer to trading on a trading floor in this book, the trading style I’m talking about may be different from that of many markets today. However, the players and behaviors are still the same. Whether you trade electronically or through a broker in a trading floor, losing money is painful. Even if you use an electronic trading system, the hedgers, cap traders, and speculators are still there, hiding behind the screen, ready to eat you alive - if you let them.”
This passage reveals the cruel side of the financial market.
The content of the first chapter ends here. If you have any ideas, you can discuss them together.
Chapter 2 explores the phenomenon of psychological biases in trading behavior that underlie the different perspectives and behaviors of inexperienced losers and experienced winners.
We will also discuss different trading styles and the market conditions that are suitable for each trading style. In the following chapters, we will see how Rich's training program can transform an inexperienced novice into a successful trader in just a few weeks.
