What Kind Of Trader Do You Want To Be?

• November 5, 1999
• Manuel Ochoa

Many would-be traders have decided they want to trade, but they soon discover they must decide exactly what type of trader they want to be. This issue is called style selection, and it is something every trader should understand before plunging real money into the markets.

Focusing on a trading style is important because of the vast numbers of securities and futures available today. While some traders decide they want to diversify and trade a little of everything, this approach still requires a process of elimination. For example, a trader who opts for the diversified approach might decide to trade broad-based indexes, government bonds and the major indexes, along with some commodity markets (such as crude oil). This guarantees that he will at least catch the broad sector moves these markets experience.

Other traders might want to specialize in more distinctive asset classes, such as emerging market stocks and bonds, which tend to have their own internal dynamics. Still others might want to concentrate on small-cap U.S. equities, which include rapidly growing companies with very volatile stock prices.

We will briefly explain a number of different trading styles, and discuss them in terms of how professional money managers might approach them, in the hope this will give traders a sense of the different kinds of areas they can focus on in the markets.

Selecting A Trading Style

Aggressive growth The trader who picks this style would usually deal in smaller companies that have, or have the potential for, above-normal growth. The risk is greater than normal because the companies usually have no earnings yet but have a good chance of significant earnings increases in the future. Consequently, these stocks tend to be very volatile and are often incorrectly priced. The trader could try to add his expertise by selling his positions when he decides (whether on a technical or fundamental basis) that his stock is overvalued.

Because of the enormous number of new companies and the rapidly changing economy, a multitude of companies fit this style. The Internet is a prime example. The growth opportunities are fantastic, but so are the risks. This can be seen in the stock price fluctuations of many Internet stocks. Developing skill in this area could be quite rewarding because of the added value the trader could contribute through his knowledge of fundamental or technical analysis

“Distressed” stocks and bonds This type of style has sometimes been called “vulture” investing or trading because of the state of the companies in the portfolio. The typical company is bankrupt or close to bankrupt.. The stock or bond price has fallen dramatically (typically 75 percent) and a management shakeout is usually taking place. A trader or investor must be able to analyze the company’s financial statements as well as become acutely aware of management’s plans to turn the company around.

Combining technical analysis with fundamental analysis can give the trader a good chance to buy or short company stocks that can produce substantial gains as the company comes out of bankruptcy. It is not uncommon to see stocks coming out of bankruptcy produce gains of 400 to 500 percent. Anyone who can demonstrate the ability to manage such price volatility can produce decent returns.

Emerging markets Emerging markets exist in countries that are still developing their economies. This is ins contrast to “emerged” markets, which exist in a stable economic infrastructure (economic policy, currency, and so on). Because emerging economies are still in the earlier stages of development, their stock and bond markets tend to be volatile. This is because capital comes and goes from those countries at a much faster rate than that of developed countries.

The trader or investor in these markets must keep abreast of the fundamental and technical conditions of the markets he is following to make quick decisions whether to hold or sell. A good example is the Asian crisis that took place in 1998, where some of the stock markets declined by 50 percent or more in a matter of months.

A trader who chooses this style should have an interest in how capital flows in and out of countries and how economic policies affect these economies. Investors who buy and hold these stocks must be able to routinely withstand large fluctuations in their portfolios. A trader can reduce the risk by actively managing (buying and selling) these stocks and bonds.

Macro style This style of trading involves following global economies and trading their bonds, currencies and stocks. The manager mainly deals in only the most liquid and widely followed instruments. The manager’s goal is not to try to figure out which individual stock or bond is going to outperform the market as a whole, but rather to make a general assumption that the market as a whole is going to rise. To capitalize on this, the manager then buys the most representative bond, stock or currency to get his exposure, so that if he is right on the market as a whole, his investment will surely go up.

As we all know, you can buy a stock or a bond that fails to move when the broader market rallies. This is quite different from managers who try to pick stocks or bonds that will outperform the market. To excel in this style, the manager must be able to follow the global economies using fundamental and technical analysis and anticipate where capital will move in the world. Today, capital moves very quickly from one country to another, constantly creating shifts in the values of bonds, stocks and currencies.

Market neutral This strategy attempts to remove the general risk of the stock market by going long one stock and simultaneously going short another. By doing this the manager is removing the risk of a major market move and is confining his risk to the relationship of one stock to another. If the market makes a large upward move, he will make money on his long position but lose on his short position.

The manager’s goal is to spot differences in the value of two companies that are directly or indirectly in the same industry and to put on a trade to take advantage of this. For example, if the manager decides that Ford is overpriced compared to General Motors, he would short Ford and buy General Motors and wait for their stock price differences to come back into line. He can use fundamental and technical analysis to come to his conclusions. This type of style requires very industry-specific analysis as compared to the macro style mentioned above.

Short selling style This strategy involves finding companies that are overvalued and shorting them for profit. To be a good manager in this style, one must be very nimble and have a keen understanding of the fundamental and technical conditions of the stocks one is following.

Short sellers must be independent thinkers who are uneasily swayed by the emotions of the market. This is especially true since most stocks over time do tend to rise, based merely on the fact that investors worldwide are biased to the long side. This can drive up overvalued stocks to even higher levels and keep them there for long periods of time, causing losses for the short sellers.

Short sellers profits tend to come in very short periods of time if they are correct, as stocks tend to drop much faster than they rise. Short sellers must instantly decide whether to take their profit or risk losing it as the stock starts to rise again. Most short sellers have had mediocre results in the last 10 years, as the bull market has pushed up even questionable companies, making this style very difficult to practice.

We have covered only a few of the existing trading styles. If you’re thinking seriously about getting into the investment business, you should carefully think about their strengths and weaknesses and pick a style that fits your own disposition. Doing this will give you the best possible chance for long-term success.

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