Understanding the Dynamics of Trading and Investing

1. Chapter 8 Why People Trade

3. Utilitarian traders • Investors and borrowers • Asset exchangers • Hedgers • Gamblers • Fledglings • Cross-subsidizers • Tax avoiders

4. Investors and borrowers • Solve inter-temporal cash flow timing problems • People • Corporations • Governments • Financial assets and real assets • Fisher’s separation theorem • Expect fair rate of return (risk free rate + risk premium) (vs. Speculators)

6. Asset Exchangers • Use markets to exchange assets that they own for other assets that are of greater immediate use to them • Spot commodity markets and foreign exchange markets • In most asset exchanges, a buyer pays money or financial assets to a seller who deliver a commodity or a currency • Investing and borrowing are special cases of asset exchanges

7. Hedgers and hedging • Financial risks (four examples) • Wheat farmers • Wholesale bakers • Traders who speculate in individual stocks • Banks that lend money at fixed long-term rates and borrow money at variable short-term rates

8. Hedging • Hedgers use markets to reduce their exposure to financial risks • They hedge risks by selling or buying instruments whose values are correlated with the risks that they face • They use forward contracts, futures contracts, option contracts, and swaps

9. Forward contracts • Farmers and bakers can manage their price risks by using forward contracts • Forward contract is an agreement to trade something in the future at a price that is set now. • A farmer would sell a forward wheat contract to a baker

10. Futures contracts • A futures contract is a standardized forward contract for which a clearinghouse guarantees the performance of the buyer and seller by interposing itself between the buyer and seller of every trade

11. Hedging with stock options • Buying a stock and put option simultaneously • In a futures hedge, the hedger gives up upside potential • In an options hedge, the hedger keeps the upside potential, but at a price (i.e., option premium)

12. Gamblers • Gamblers are not speculators • Gamblers are uninformed traders • They trade for entertainment • They are foolish if they believe that they will be successful speculators • Many stock traders who think that they are speculators are actually gamblers (unless they can clearly articulate their reason for trading) • Gamblers are not necessarily bad for financial markets

13. Fledglings • Fledglings trade to learn whether they can trade profitably • Fledglings become profit-motivated traders if they learn to trade profitably • Fledglings who cannot trade well, and who continue to trade, are futile traders • Luck vs. Skills • Learning trading is similar to learning disciplines like medicine, engineering, sports, and management

14. Futile traders • Futile traders expect to profit from trading, but they do not profit, on average • Futile trades include inefficient traders and victimized traders • Inefficient traders lack the skills, resources, and access to information necessary to trade profitably. The most common type is the pseudo-informed traders who believe that they are well-informed, but actually are not. • Victimized traders rely on brokers, advisors, or employees who fail to meet their fiduciary responsibilities