One beta tester of the software I’m developing
focused on finding correlations between headlines and stocks initially, but eventually applicable to almost anything
asked me:
“What do I do if it says sell, but I didn’t own the stock?”
A simple question.
But it made me realize I had made an assumption while building the software.
I assumed that anyone interested in actively trading the market understood that there are two basic directions you can trade.
You can buy a stock because you think the price is going higher.
Or you can trade expecting the price to go lower.
We have words for these things: going long, going short, selling short, covering a short. Wall Street has an entire thesaurus room filled with variations.
But my beta tester’s question exposed something much more important:
A market signal and a trade instruction are not necessarily the same thing.
If my software says “SELL” and you own Apple, the meaning seems obvious: sell your Apple.
But what if you don’t own Apple?
Does SELL mean:
Don’t buy it?
Wait?
Get out if you own it?
Or actually short the stock and try to profit if the price falls?
Those are very different things.
And that last one introduces another problem: risk.
When you buy a stock normally, your theoretical maximum loss is what you invested. If you buy $1,000 worth and the company somehow goes to zero, you can lose $1,000.
Shorting works differently.
In the simplest terms, you sell shares you don’t own
typically shares borrowed through your broker
with the intention of buying them back later at a lower price.
Sell at $100.
Buy it back at $80.
You made $20, before fees and other costs.
But suppose instead it goes to $200.
Now you’re down $100.
Suppose it goes to $500.
You’re down $400.
A stock can only fall to zero. There is no theoretical limit to how high it can rise.
That’s where the phrase “unlimited risk” comes from.
Of course, saying “unlimited risk” makes shorting sound like you’re walking into a casino carrying your mortgage documents.
Most short trades don’t end with someone losing everything. Otherwise the brokers would be on the hook until you pay it back.
There are position sizes, margin requirements, stop losses and other ways traders attempt to control risk.
But the risk is structurally different from simply buying a stock.
So I stopped what I was currently doing to address this issue.
We are now working on giving users different options depending upon what they actually want to do.
Maybe the software shouldn’t simply say:
BUY / SELL
Maybe it needs to distinguish the different user.
Because someone who receives a bearish signal doesn’t necessarily need to short the stock.
They might simply avoid buying it.
They might sell it if they already own it.
Or, if they understand short selling and are comfortable with the additional risks, they might choose to trade the decline.
The user should know which road they’re getting onto before hitting the accelerator.
I always like car examples when talking about trading.
Driving a car can be dangerous. We don’t solve that problem by telling everyone not to drive. We build brakes have speed limits and bright paint to distinguish lanes.
And we teach people what the signs mean like what I do in my posts and in the software.
If most people who drove ended up in the ER, nobody would be crazy enough to do it.
Trading software should probably work the same way.
And then there are motorcycles.
I’m not sure what the accident statistics are on motorcycles, but almost everyone buying one understands that they’re not buying a Volvo.
They know what they’re getting themselves into.
That’s probably the lesson I learned from one beta tester asking what seemed like a very simple question.
I thought I was building software that identified market signals.
I’m actually also building the dashboard, warning lights and road signs that explain what someone can do with those signals.
There is a difference.
And sometimes the person who knows less about your product is the person who discovers the assumption you didn’t realize you had made.
If you want to be part of the new generation of traders that use the news like basically every institution and hedge fund already does, subscribe to my premium version.
PS. Today I’m also rolling out daily commentary using the metrics we have talked about the past year
Carpe Diem
Eric
