Traders play a different role from brokers and analysts
During my time as a convertible bond trader I received an email from a salesperson from a large US investment bank. The email contained a research piece about a convertible bond that his firm was recommending; the piece ran to a number of pages, and it looked comprehensive. Skimming through the research I disagreed with some of the assumptions that were underlying the analystâs view that the bonds were cheap. Later that morning I received a call from the salesperson asking what I thought of the trade idea, and whether I would like to buy any of the bonds. My first question was, âDo you have any of the bonds or will you need to go to the market to buy them?â His answer was that his firm had $10 million of the bonds on their books, ready to sell.
I now had all the information I needed to decline the trade. Here is what had probably happened: another trader sold $10 million of these bonds to this US bank, or the bank had them on its trading book. The bank then decided to sell these on because they didnât want them on their own trading book. This is usually because they believe the bonds are too expensive. An analyst was then tasked with preparing a research piece advocating the cheapness of the bonds, which required the inclusion of some dubious assumptions. The brokers could then go out and sell the bonds. This is often how the sell side works.
In my writing I use the terms âbuy sideâ and âsell sideâ. I would expect that for many readers itâs the first time they have heard of or read those terms. In the professional industry (investment banks, hedge funds and so on) they are commonly used and well-understood terms but, as with many other aspects of the professional trading business, this knowledge is not evident among retail traders. So my first task is to explain what they mean and why itâs important for you to understand the difference between them. Once you do, much of the rest of this chapter, and perhaps this book in general, will be clearer.
Sell side
It is probably easier to start by looking at the sell side. The sell side of the industry is tasked with selling products such as shares and bonds. The two most common jobs on the sell side are brokers and analysts. Investment bank desks have a third position: salespeople who are in effect institutional brokers who sell to hedge funds, managed funds, and so on.
Itâs very important to understand that brokers and analysts are employed to sell; they construct stories, research papers and so on, designed to help them and their firm achieve their goal. As commissions and therefore income are increased by selling more, hopefully you can understand why selling is so important in the financial world. For company analysts, for example, sell recommendations are usually rare because they understand that most share market investors only trade from the long side (they buy shares), so sell recommendations will not help them achieve their goal of generating commissions for the company.
Brokers are typically paid on a commission basis; the more commission revenue they generate, the more they get paid. Personally, I see this as a conflict of interest; how can they give their clients the best advice when they need to generate commissions to earn a living? There will undoubtedly be many days each year where no decent trade ideas can be generated, and traders should be patient and do nothing. But brokers will struggle if they give that advice to their clients.
Some argue that itâs not in the brokerâs interest to churn and burn clients, as they will continually need to get new clients. But that is exactly what occurs each and every day, hence the need for broking firms to continually advertise. If their advice was really that good, word would spread quickly and clients would recommend the broking firm to their friends. In my experience this is the exception, not the norm.
If you watch any of the 24-hour financial news channels, the various industry faces that you see and hear will almost always be brokers and analysts. They have simple, clear messages, present well and have all the attributes of salespeople â which is, after all, what they are. Similarly, quotes in newspaper or online articles are usually from brokers and analysts too; they are the faces of their organisations, and presentation is as important as knowledge for many of them. Sell side individuals who appear regularly on TV or in the wider media can command higher salaries simply due to their profile, regardless of their performance or the accuracy of their recommendations. (If sell side individuals were paid on performance, like traders, Iâm sure they would on average earn far less than they do.)
Buy side
Traders, hedge fund managers and even pension (superannuation) fund managers are on the buy side of the business. These are the individuals and teams who make the trading and investing decisions, and they carry the risk of the trades. They receive daily calls and emails from those on the sell side trying to sell them various trades or investments, but their job is to critically analyse those recommendations, as ultimately it is the trader or fund managerâs job to make the trading decision. Those on the buy side rarely appear in the media, and it does not matter how they present, because they are paid to deliver in terms of trading profit or fund performance. Those on the buy side must weigh up the risks of each trade; they stand to lose their job if they consistently enter into losing trades. Compare that with your broker; if he or she recommends a dozen trades to you, which you enter into, and they all lose, which is most likely?
- The broker loses their job.
- You lose your trading capital.
Bearing in mind that the broker has been successful in achieving good commissions for his or her firm, I would suggest the most likely answer is âbâ.
My role as a trader is obviously very different from that of brokers. I need to be able to see through the sales techniques and come to my own view on whether these are good trades. Conversely, when I want to sell one of my positions, I instruct our sales team to pitch the trade to their clients. Clearly I will only be exiting a trade if I believe there is little profit left in it, but there are always other opinions and itâs up to the sales team to find reasons to place the position elsewhere. You can see why good salespeople are crucial to trading desks if they can help traders get in and out of trades.
As a trader, there will be days when I decide there is nothing to do. As I am not commission-driven, I am more than happy to sit with my current trade or sit out of the market if that is what my analysis tells me is the right thing to do. My only goal is to keep making good decisions, as good decisions will lead to a long-term, sustainable trading career.
So it should be evident that traders are very different from brokers and analysts. Traders need to be good decision makers, and they need to be patient. They have to weigh up various risks and outcomes, which means that trading decisions are not always simple and clear cut. Sell side individuals, though, are involved in creating reasons and stories why traders should enter into a trade.
If I were to go back to a car analogy, I would explain the roles this way. Analysts are like mechanics â they understand the theory of how the car should run, but that doesnât mean they can drive the car around a racetrack in the best or fastest way; theory and reality can differ. Brokers are like car salespeople â they are not experts on how the car works (although they know enough to sell to customers) and they also usually donât possess the ability to be a racing driver and get the car around the track intact and quickly. They are very good at selling cars, though.
Traders are the racing drivers of the industry. They should understand the theory that analysts (mechanics) do, but they must then apply it to the real world. They must understand the past, but they need to make decisions on how they see the road ahead. Regardless of whether the track has been clear on previous occasions, racing drivers are not racing the previous lap; they are racing the current one, and this time might be different. They cannot predict what will happen in three or four lapsâ time, because there are too many uncertainties beyond our control. What our driver (trader) can do, though, is to constantly re-evaluate the situation and make adjustments when necessary. Traders do not need, and rarely possess, sales skills, and so would tend to make lousy salespeople.
Donât get me wrong, brokers do have a place in our industry, in the same way that we use real estate agents and car salespeople. A brokerâs role should be to assist a trader, if required, in executing a trade and advising on order flow; brokers that are good at this are well worth using. It is vital, though, that traders learn their analysis and trading techniques from other traders, not from brokers and analysts. As I will discuss, in many instances this does not happen.
The âotherâ junk-food industry
Some years ago, when my son was about four years old, he asked me, âWhy do junk-food restaurants sell food that is [allegedly] bad for you?â (He didnât use the word âallegedlyâ, but for the benefit of any lawyers who are reading this, I have added it!) The answer was, of course, simple: âBecause people want itâ and, as we all know, successful businesses are usually built on giving people what they want. Sometimes though, as with junk food, what we want is not good for us.
In trading we have our own âjunk foodâ industry: an industry that has evolved to give people what they want, because that is how firms make money. Unfortunately, though, what retail traders typically want is not whatâs good for them. As Cass Sunstein and Richard Thaler state in their book Nudge, firms have more incentive to cater to irrational practices than to eradicate them.
Letâs examine a typical new retail trader. What does he want (and what doesnât he want) to hear? The first thing he wants to know is that he can and will be profitable. He wants to believe that a simple trading plan with some easy-to-understand entry and exit points can lead to a profitable trading career. He wants a form of analysis that does not take up much time, but that somehow can still deliver great results.
The newbie typically does not want to spend a significant amount of time learning about the mechanics and fundamentals of markets â they want a form of analysis that cuts through that hard work. They do not want to hear that trading is hard work and that many will fail. With these ideas in mind, the new trader will seek out those who provide the messages he wants to hear.
Luckily (or not) for most new traders, the industry is more than happy to tell them what they want to hear. And so begins the exchange of funds from the new trader to the industry. This is all a part of the financial junk-food industry.
One of the key reasons why retail traders are so attracted to the financial junk-food industry is because of the skills of the sell side individuals who dominate it. Their job, as we have discovered, is to bring new entrants into the markets and then to sell them as many contracts or products as they can. A large percentage of the books, courses and presentations for new traders are actually written by analysts and brokers. As many retails traders donât know the difference between traders and brokers, they will use these resources when learning to trade.
Take this example from an advertisement for a seminar for would-be traders. The presenter of the seminar who was supposed to be teaching the new traders was described as â⌠formerly head of technical analysis ⌠for over 17 years. Learn from an experienced traderâ.
Not only is this person an analyst, but he is a technical analyst (which is often just an astrologer of the markets, as discussed later). He is not a trader â the statement saying so is incorrect.
As both Taleb and Kahneman have explained, people prefer simple, clear messages and the sell side is very good at providing that. They tell you that there are straightforward paths to trading success, or âsecretsâ that...
