How Does Anyone Make 60% Per Year?

Did you see the Frontline piece on insider trading?  Was very interesting to watch.  I have a very different perspective than the mainstream on insider trading.  While many people might find it hard to believe that a trading firm can earn 60% return per year, I don’t.  If they were insider trading on everything I find the number low.

If you knew what the stock price in tomorrow’s paper was going to be, how could you lose?

If you are a great trader, you can earn far more than 60% on your money.  If I was actively trading and committed $100,000 to an account, I’d want to earn magnitudes of that.  More like a minimum of 250% or more over the course of a year.  It’s why traders go into the business.

But, earning that kind of return means that there is also a high probability that you could lose it all.  That’s why information is a powerful currency on both LaSalle and Wall Street.  At it’s core, trading is about variance.  The greater the spread of the distribution of potential outcomes, the more money you can potentially make.  More certainty, less money.  It can be illustrated like this:

Traders don’t think like regular humans. They think in terms of variance and risk/reward.  This is an important concept to remember whenever insider trading is mentioned or contemplated.

The documentary focused a lot on “first call”.  It is hardly surprising that the best clients get a first call.  All the economic incentives line up to have that happen.  If the government banned first calls, the street would just figure out a different way to alert their customers.

First call gives traders a slight edge.  Especially in this day of hyper speed trading.  All information is immediately translated to machine readable formats.  As soon as it comes out, HFT traders can act in milliseconds.  That puts human traders behind the 8 ball when it comes to trading on information.  First call can mean the difference between making money, and losing. Even if you put the right trade on.

I want to be clear that this isn’t “good” or “bad”.  It’s just a function of how quickly public information gets priced into the marketplace.  Eugene Fama received a Nobel Prize for identifying that concept mathematically and empirically.  Before computers, there were people that had information and beat the rest of the market to trades.  There is no place on earth more competitive than trading on an exchange.  Nowhere.

Brokerage firms don’t make money when their clients sit still.  That’s why there is so much information noise in the marketplace.  Most of it is put out by the brokers in order to create uncertainty, or a false sense of certainty to get clients to trade.  Churn and burn clients get the best treatment.  They always will.

It’s important to remember, all documentaries are made with a point of view.  This one is made with the point of view that all of Wall Street is dirty.  Some of it is, but it’s also important to note that a lot of the things they uncover are pretty fuzzy.  It’s hard to have red lines with hard and fast rules when it comes to information flow.

When it comes to trading, it is not just analysis of financial statements.  Financial statements are pretty meaningless to the future price of a stock.  They are a record of what was, not what will be.  What the financial statements do is give you clues as to the operations of the company, and potential future land mines.  Expectation theory drives future prices.

The real advantage in trading comes from “proximity”.  Proximity can be defined a lot of ways. Proximity in a trading pit was how close you stood to the largest order filler.  In the commodity business today there are two proximity advantages.  One, the exchanges sell to their customers. It’s called “co-location”.  Customers pay millions to be close to the processing engine of an exchange.  Speed is an advantage because you can act first. The other is information proximity. Information proximity is available to anyone.  It’s work to build a network.  Or, you can pay a centralized expert network to get the information for you.   If you have a good enough network on a particular commodity, you can create a position for a longer term trade to take advantage of that information.  The trading floor perpetuated itself for centuries because it was a fabulous information network.

Proximity in the stock business might be running your own dark pool and paying for order flow from retail brokers.  It could be information from trusted sources that give you a leg up-a first call.  It could be speed of execution.  Proximity could also be just using your own customer orders and trading against them.  If you think your retail broker order ever sees the light of day in a competitive marketplace with lots of players bidding for it, you are living in a dream world.  All these versions of proximity are legal and endorsed by the SEC-even though they are anti-competitive to the broader public market.

Frontline takes a position that “expert networks” are bad because they are unregulated.  Expert networks exist everywhere and have for centuries.  They exist in every industry, and in most cases aren’t even used for trading.  Expert networks make it easier to get information.  If the government decided to regulate them, they would still exist. Regulation would just raise the cost to utilize them.  Traders would pay it.

People spend their lives creating networks of information.  There are people in the commodity industry that have ties to all levels of distribution in particular commodities.  Many of them pay for private analysis of things like crop reports that are not available to the public.  They create a book of positions from this information and commit risk capital to them.  I don’t see a thing wrong about that.

Private crop reports aren’t always correct.  Different people interpret the same information differently and take different courses of action with it.  Trading isn’t linear.  It’s abstract.

In stocks, it’s a little different.  The documentary uses an example about material facts on a financial statement that are released before the public knows.  Certainly, that is crossing a line.  But, to me if a person made a generalized statement that they knew orders were down in a certain place, it’s not specific enough to cause me to get an edge on the market.

In some cases, there is certainly inside information that gets passed through an inside network.  But, if you are a good trader, you don’t rely on that source alone.  There is simply too much risk.  Good traders assemble information from a variety of sources and then act.

In the documentary, there is a story about a pharmacist that feels he got burned by insider trading.  Hardly.  He took risk and accumulated a position.  He felt really good when he saw a big player enter the market and mimic his position.  When it turned around, he wanted to blame the inside trade that looks like it certainly occurred.  But, would the stock have performed differently without the insider trading?

No way.  Once the negative information came out, the stock would have done the same thing.  In this case, because SAC got out and reversed it’s position, I could make an argument that it would have been even worse had they not gotten out ahead of the information release.  The pharmacist would have lost even more money because in the rush for the exits, SAC and HFT traders would have gotten through the door well ahead of him.

“Rules are rules and the law is the law”.   The district attorney that uttered those words might think that, but it’s certainly not the case in America.  Rules are bent all the time.  Words in statutes are written so that friends of people in high places can hide behind them.  Entire government agencies walk in lockstep with their corporate partners to get things done.

There is no written word in any US legal document that isn’t interpreted.  President Bill Clinton redefined the word “is” in a deposition on Monica Lewinsky and the Supreme Court is constantly challenged to redefine laws. Even plain written texts like the Bill of Rights are subject to constant torture and revision.  It is a fallacy to think that things are black and white.

It’s also important to note, the government’s investigation used technological sources that are antique.  Email, texts and phone calls are but one way to pass information around.  There are hundreds of apps, and ways to get things from one place to the other.  It’s probably impossible for any regulatory agency to stay ahead of the game.  That’s why making the marketplace flat with virtually no chains of distribution is the better way to curb abuse.

Don’t get me wrong, I think that the government needs to be vigilant on insider trading.  But, the government is two faced.  It chooses who to prosecute, and when.  Many times it gets it’s marching orders from an entity that has a stake in the outcome.  Until the government changes core regulations that make the playing field level for everyone that participates in the market, don’t get any joy seeing a small amount of individuals go to jail.

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• Did “Frontline” Go Too Far?
• Insider trading laws aren’t adapting to new markets

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