Price Discovery Explained For Beginners

Financial Advise
What is Price Discovery

Price discovery is the process where buyers and sellers determine where a transaction can take place based on supply and demand.

This evaluation process uses the economic concept of supply and demand to find a price where a buyer and a seller agree to trade.

The supply and demand for an asset are based on several factors including the future abundance of an asset in any specific location. Transaction costs, as well as transportation costs and the storage of an asset, can play a pivotal role in determining the price discovery.

The formula to determine price discovery is ever-changing and will be different for each asset.

Why It’s Important

Did you ever notice that when a new company stock trades for the first time on an exchange like the NYSE, it can take a while for buyers and sellers to agree on a price?

What generally occurs is that buyers move their bids higher and the seller moves their offers lower until a trade is transacted. This process is called price discovery. Its were buyers and sellers agree to a price to allow a transaction to take place.

The process of setting a price on any asset, whether is a security a commodity, or currency pair is referred to as price discovery.

Traders will evaluate several factors including supply and demand, risk, politics, as well as the economic environment during the price discovery process.

How Does It Take Place

The study of price discovery is a relatively new theory, but the concept has been around for thousands of years.

Every barter for goods or services is part of the price discovery process.

Every street market where a vendor is willing to negotiate participates in price discovery. As you can imagine this will change from transaction to transaction.

The Development of Price Discovery

The bizarre in China and India provided some of the first marketplaces around the globe. The issue for buyers and sellers was that the same product could trade simultaneously in separate locations and experience different prices.

The supply and demand in a specific location could be very different and it could take weeks or months for buyers and sellers to realize that prices were higher or lower at a different location.

For prices to be consistent they rely on traders to close an arbitrage.

The term arbitrage means the simultaneous buying and selling of assets in different markets to take advantage of differing prices.

A location arbitrage means that the price difference allows you to transport the price from one location to another and still make a profit.

Vehicles and the telephone helped close location arbitrages around the globe.

The modern-day marketplace has morphed from an in-person ring of traders to an electronic auction where traders place bids and offer to help in the price discovery process.

The advent of an electronic auction has increased market transparency, but still provides scenarios where trades can simultaneously take place at different prices.

Sophisticated electronic trading programs are constantly scanning all possible electronic trading platforms to take advantage of any price anomalies.

Price Discovery in the Marketplace

Price discovery is the most important function of a marketplace.

Every market participant has a reason to purchase and sell at a specific level.

As markets become transparent, the liquidity that is provided creates a smooth movement in price action. Consistent price movements due to observable price discovery increase confidence in a market.

When price discovery is opaque, investors tend to shy away from trading.  Opaque markets tend to have wide differences between where traders are willing to purchase and sell an asset.

Generally, fewer traders are involved in opaque markets.

While the difference between the bid and offer will narrow to generate a trade in an opaque market, investors understand that exiting a position could take time.

For example, you should be confident that you can exit a position in Apple shares immediately after you purchase them. This would not be the case if you decided to purchase a cabin in the middle of an uninhabited rural area.

One of the downsides of a highly transparent asset is that large quantities can be moved quickly which can generate whipsaw price movements.

When it Concerns Day Traders

Price discovery mainly concerns day traders on days IPOs open up for trading and there is no previous price action to trade off of.

In the first few hours of trading, shares can be very whippy and hard to trade. This is because it’s the first time the shares have traded on the open market which means there are no real levels of support and resistances.

This means shares can be very volatile. Trading with that type of price action can be hard to manage risk which could end up costing you a lot of money.

One way to approach IPO trading, especially for beginners, is to let the morning trading cool off. Let the stock establish levels of support and resistance.

This will give you something to trade off of and provide you with a way to manage risk.

In the example above, Palantir Tech (PLTR) opened up for trading on September 30. Prices were going back and forth between $10.20 and $11.40 before settling down and establishing and trading range.

Then you can see that at $10.60 prices started to hold on multiple occasions before breaking down and trading lower for the rest of the day.

This is what you want to wait for, especially on IPOs.  Allow prices to establish some sort of price discovery to trade from and then take advantage of the moves when they breakup/down.

Price Discovery and Valuation

When markets are active with thousands of traders placing bids and offers, they tend to be transparent. The price discovery process can be relatively easy. Price discovery is not the same as valuation.

The process of trading uses a model-driven concept to determine that the current price is either overvalued or undervalued relative to future prices. This differs from price discovery which is a market-driven concept that determines the current price of an asset.

Terms such as fair value, focus on the future value of an asset relative to price discovery which is geared to determining the current value of an asset. For traders, price discovery provides a key metric for determining future price values.

For example, if you don’t know the price today, you cannot bet on the future price value.

What Influences Price Discovery

Several factors influence price discovery.

Some of these impetuses include:

  • Availability of an asset
  • The demand for an asset
  • The available information
  • Whether the asset is fungible (meaning it’s the same assets in all locations)
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What Is The Best Strategy For Small Accounts?

Financial Advise

Most people often start to day trade with a small account and then build their bankroll and skills as time goes by.

Not only is starting out small a great way to limit your losses, it is also an excellent way of gaining the experience you need to be confident.

A small account requires you to make smarter stock selections since you don’t have as much capital to throw around. So being picky is a good thing!

But what is a good strategy for small accounts?

There is no one perfect strategy – no matter your account size.

However, we have found the bull flag pattern to be a great beginners day trading strategy that is easy to learn and identify.

Trading a small account

If you are going to be trading with a small account, you will not have a lot of room for error. Entries will be key for managing your risk so be patient and pick the best possible spots to get in.

Ensure to stay away from setups that are not A+.

Your main goal with a small account is to protect your capital and take profits when you can. It will be a grind but as you grow your account you will allow yourself more of a cushion to take more risk on.

Additionally, you have to exercise extreme patience while waiting for your setup to evolve and trigger a buy/sell signal in a small account.

Don’t just trade to trade as that will almost certainly send your account down the drain with fees and losses hurting your capital.

You also need to know when to jump out of a trade and trim your losses before they mount. That means you need to learn how you to use a stop loss order and a popular profit-taking strategies that are used by day traders.

Discipline is key no matter your account size, but it is especially important when you have limited capital.

Why stock selection and risk management is crucial

Stock selection and risk management skills are critical in trading a small account.

The market has thousands of stocks, ETFs, and mutual funds that you could trade. Traders have to pick between 5 to 10 stocks worth trading daily, and maintain a decent accuracy of winners versus losers in order to make profit.

They do this by looking for stocks that have big upside potential. Almost every single day, there is always at least one stock makes a 20-30% intraday move. These are the types of stocks professional day traders love.

To get a piece of the action, traders usually jump into these stocks as soon as one of them starts popping up. Keep in mind that the stock market runs on crowd mentality and rumors, so when a stock begins to make a move, other traders get on the bandwagon.

However, it’s important to remind everyone that just because some experienced traders can make stock selection easy, it does not mean profitability is easy.

Trading is difficult, and it requires quite a lot of dedication to make consistent profits.

Bull flag pattern

While there is no bullet proof strategy no matter the account size, we favor the bull flag pattern for trading a small account, due to its low risk entry points with potential big winners.

A bull flag is a chart pattern that forms when a stock is in a strong uptrend. The reason why it is called a flag pattern is because when it forms on a chart, it looks like a flag on a pole and since we are in an uptrend it is considered a bullish flag.

Typically, a bull flag pattern has the following features:

  • Stock has made a strong move up on high relative volume, forming the pole.
  • The price of the stock consolidates near the top of the pole on lighter volume, forming the flag.
  • Stock breaks out of consolidation pattern on high relative volume to continue the trend.
Bull flag chart pattern
How to trade the bull flag pattern with limited capital

Bull flag patterns are an excellent setup for traders with small accounts or limited capital because they are easy to identify once you understand what to look for.

Like most patterns, volume must be present on the breakout. This confirms the pattern and increases the likelihood that the breakout will be successful.

Here is a checklist for trading bull flag patterns after identifying one:

  • Stock is moving up on high relative volume, preferably from a news catalyst like earnings or CEO resignation.
  • Stock consolidates at or near highs with a defined pullback pattern.
  • Buy when the stock breaks out above the consolidation pattern on high volume.
  • Place a stop order below bottom of consolidation pattern.
  • Your profit target ought to be at least 2:1 risk/reward. Therefore, if you are risking 30 cents, then first profit target is 60 cents from your entry price.

Trading the bull flag is pretty straightforward and strategy that any aspiring trader can learn.

The challenging part of trading this pattern is spotting it in real-time.

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Want To Become A Day Trader? Here Are The Pros And Cons

Financial Advise

Day trading has grown in popularity particularly in the past year as more and more individuals sought financial freedom and the ability to live life in a way that is meaningful and fulfilling to them amid the global coronavirus crisis.

The surge in amateur day traders has helped to create a record number of new accounts at brokerages like Robinhood, TD Ameritrade, and Charles Schwab (NYSE: SCHW).

Such small-scale traders now account for a fifth of overall stock-market trading activity, according to some estimates.

In this article, we will dig deeper into the main benefits and downsides of day trading to help decide whether day trading is the right thing for you.

What Is Day Trading?Day trading is one of the most common trading styles that is used by traders around the world.

This speculative trading style involves opening single or multiple trades during a day and exiting them by the end of the current trading day.

Simply put, day trading is the act of buying and selling stocks on the same day, based on price fluctuations.

Example

If you open a new position at 8:45 a.m. and close it by 2:00 p.m. on the same day, you have completed a day trade.

If you were to open the position and fail to close it later that same day, it would not be considered a day trade.

Unlike in position trading or swing trading where trades are held for weeks or days, day traders can immediately analyze their trading performance by the end of the day.

Day traders generally spend over 2 hours every day to watch short term price movements and trade setups. They use advanced charting systems that are plotted by 1, 5, 15 or 30 minute intervals.

Pros Of Day Trading

Under the right circumstances, day trading can be an amazing career option with plenty of benefits. Let’s take a look at a few of them.

However, this line of work isn’t for everyone. Successful day traders need to be self-motivated, disciplined, levelheaded and financially independent.

If you’re thinking about pursuing a career in day trading, compare your own personality profile against this list of key characteristics and personality traits.

  • You are your own boss

To begin with, most day traders work from home and don’t have hard-nosed bosses telling them what to do at all times. Even better, successful traders may earn enough money to live life comfortably.

They simply stay on task during trading sessions and commit to intensive preparation and research sessions. After settling upon a profitable strategy, they stick with it until it no longer works.

  • Day trading provides you an opportunity to earn a comfortable living

There are not many things that can equal the emotional high that comes with a sweet profit achieved solely by the effort of a single individual.

As a day trader, you have the opportunity to make a great living, provided that you have a well thought out strategy, understand the inner workings of the financial markets, and can afford to take the risk.

For example, on March 7, 2015, an options trader raked over $2.4 million based on a single news wire in just 28 minutes.

According to CNBC, the trader executed the trade after a respected Wall Street Journal reporter tweeted at 3:32 pm that Intel (NASDAQ: INTC) was holding talks to acquire Altera.

Shares in Altera began to shoot up, so much so that the stock was halted after only three minutes at 3:35 pm. But within that short time period, the trader was able to place a bid for 300,000 Altera options at $36 a share.

At the closing bell, Altera shares were up $44.39 helping the trader to make more than $2.4 million.

Granted these types of gains are not normal and shouldn’t be expected especially if you’re just starting out. But it is possible.

You can also make or lose more money by utilizing leverage i.e., money that you borrow from your broker to in order to trade more, which most day traders use.

  • A variety of trading strategies

Day traders has several trading strategies they can use to trade across all major markets. Some of the most popular day trading strategies include trend-following, breakout trading, and counter-trend trading.

  • Overreaction to news

Markets consist mostly of humans, and they tend to overreact to news.

This is why you will see big price moves when certain news is released. Day traders often take advantage of that behavior and squeeze out extra profits.

Volatility is what day traders look for.

Cons Of Day Trading

Day trading can be rewarding, but it also carries a high risk. First, there is never a guarantee that you will earn money.

As a matter of fact, the U.S. Securities and Exchange Commission (SEC) says that “day traders typically suffer severe financial losses in their first few months of trading.”

A good example is what happened in late January during the Gamestop Reddit mania that puzzled Wall Street and triggered federal scrutiny.

Shares of some heavily-shorted stocks including Gamestop (NYSE: GME) rocketed to record highs before plunging back to earth.

While some traders made a fortune by trading these stocks, those who failed to time the trade perfectly lost money.

Here are two other top risks in day trading:

  • It requires capital

Day traders need to have the right computers and software to access the necessary financial information and spot the price variations.

The U.S. law also requires that day traders maintain a minimum of $25,000 in their trading accounts at the end of the trading day if they want to make at least four round-trip trades over a period of five days.

In addition, taxation can become a nightmare because you may acquire capital gains and losses when day trading various instruments available in financial markets.

  • Success tends to be closely tied to the state of the current market environment

When the market is in a period where there is no huge upward or downward moves, day traders often lose their cash by churning their accounts and holding onto losers too long.

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How Many Day Trades Can You Make In A Week?

Financial Advise

As with kicking off any career, there are plenty of things you should learn if you have dubbed yourself a brand-new day trader.

Not only will you need to decide what to trade, when to trade, how to manage your risk, but you’ll have to get the right software and equipment, and of course, determine how many day trades you can make in your brokerage account.

In this detailed guide, we will go over how many day trades you can make in a week depending on what type of account you have. 

What is a Day Trade?

A day trade is when you buy or short a financial instrument and then sell or cover the same instrument in the same day with the goal of making a profit.

For example, if you buy 100 shares of XYZ stock at 9 am and sell all the shares at 1 pm on the same day, you have completed a day trade. Just opening, without closing that position that same day, would not be considered a day trade.

Another day trade example is when you open a position to purchase 200 shares of XYZ stock at 9:30 am, followed by a purchase of another 200 XYZ shares at 2:30 pm, followed by a sale of 400 XYZ shares at 4 pm.

In addition, if you short sell 150 shares of XYZ stock at 9:30 am and then open a buy position to cover 150 shares of XYZ stock at 10:30 pm, you will have made another day trade.

Individuals who indulge in this style of speculative trading are known as day traders. The most common day traded financial instruments are stocks, futures, and forex.

Day traders typically make use of technical analysis tools and a trading strategy to try and profit off within a short period of time and will often take advantage of portfolio margin to boost their buying power.

Successful day traders don’t just trade any stock they come across. They have to be fully prepared with a well-planned strategy and employ a wide variety of techniques.

Cash Accounts and Margin Accounts

If you are looking to day trade securities, you can do so using an online brokerage account. Generally, there are two main types of brokerage accounts: cash account and margin account.

The difference between a margin account and cash account is that the margin account lets you borrow from your broker while the cash account does not.

In other words, when you open a cash account with a broker, you will be required to pay in full for the securities you buy for your account. If you have $200, you can only buy $200 worth of securities, and can’t use the securities in your account as collateral to borrow more money.

On the other hand, if you open a margin account, you can borrow money from the broker to buy securities, using those securities as collateral for the loan. Generally, when applying for this type of account, the process has to be approved by the broker to make sure you are qualified for the account.

Margin accounts also come with special features for active traders, like short selling.

Now that your understand the difference between the two accounts, let’s dig deeper to find out how many day trades you can take in a week in a cash account and how many you can take in a margin account if you are under $25,000 and if you are over.

How many day trades you can take in a week in a cash account?

One of the main benefits of day trading using a cash account is you can place as many day trades as you would like until you cash is used and won’t be held to the pattern day trading rules in a margin account.

But you will have to wait for your trades to settle before you can proceed to use that cash again. Typically, it takes one day from the trade date for options and two days from the trade date for stocks.

Example: If you have $10,000 in your cash account and you buy and sell $2,000 worth of stock, then you have $8,000 left to day trade until the $2,000 you used settles in two business days.

Cash accounts don’t follow the dreaded Pattern Day Trader Rule (PDT) rule that may prevent traders with less than $25,000 equity in their accounts from executing 4 day trades or more in a 5 day period. This is a huge benefit for traders who don’t have the extra $25,000 lying around.

The PDT rule was implemented back in 2001 by Financial Industry Regulatory Authority (FINRA) as a safety measure to help minimize the risks associated with day trading.

How many day trades can take in a margin account if you are over $25k?

When trading on a margin account, you will be subject to the pattern day trading rule, meaning you will be required to maintain a minimum of $25,000 in equity in your account if you place more than 4 intraday roundtrip trades in any rolling five-day period.

If your account is labeled as a pattern day trader, you will have to maintain that account minimum and if you don’t, you will not be able to day trade.

If you do have the minimum equity requirement in your margin account, you will be given day trading buying power which is 4x more than normal amount.

So, if you have $26,000 in your margin account, for example, you can trade up to $104,000 per day as long as you maintain the $25,000 minimum margin amount.

Keep in mind that day trading buying power can not be held overnight.

How many day trades can take in a margin account if you are under $25k?

If you have less than $25,000 in your margin account to day trade, you can get around the PDT rule by making only three day trades in a five-day period. But this means you’ll need to pick a stock from several valid trade signals, so you are not going to receive the full benefit of a proven strategy.

Essentially, if you have a $5,000 account, you can execute three-day trades in any 5 consecutive trading days. Once the account value surpasses $25,000, you will not be affected by the PDT restriction.

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Why You’re Not Making Money Consistently With Your Trading

Financial Advise

The stats are pretty clear – over 90% of people who day trade are not able to generate consistent profits.

This pretty shocking statistic means only a handful of traders actually have anything to show from their day trading activity and some have sadly lost money.

And still millions of people around the world still engage in day trading, many of them on a regular basis.

Once primarily practiced by professional investors, day trading is increasingly becoming popular thanks to superior online trading platforms and free-stock trading apps such as Robinhood.

But what is going on? Why do so many people lose money while trying to profit from market fluctuations and how can you join the 10% of traders who are consistently profitable enough that they have made it their full time living.

Why Most Traders Lose MoneyLike Ross Cameron says, day trading is the hardest yet easiest job in the world. What he means by that is that you can trade on your laptop from home or a hotel room from almost anywhere in the world, as long as you are connected to the internet.

It is an easy and amazing job.

You are not hammering roofs in August or going out on the highway in 10 degree below weather in the middle of January. But while day trading is a pretty nice job in a lot of ways, it is very hard in some aspects since 9 out of 10 traders fail.

So, what are some of the reasons for those failures and why do most traders struggle to turn a profit.

  • They lack of a trading edge/strategy

One of the reasons why most traders fail to bring their trading to its full potential is because they trade without an edge or strategy that works. Most traders don’t even have a clue what a trading edge is, let alone how to develop one.

A trading edge is when you can identify something in the market that gives you an advantage or insight into how well a trade will do.

Whether you are a beginner trader or have been trading for some time, a trading edge is necessary as it can greatly keep you on track to achieve profitable and steady trading results.

  • They fail to review their trade results

The second reason is because they don’t keep a record of their past trading activities that they can go later study to sharpen their skills.

Chess masters keep journals to record down their thought process of the game and their plays. Scientists have journals to track their latest findings and the results of their experiments.

This should be the same for traders! Unfortunately, only a few traders have a trading journal that they use to review their trades.

  • They trade with emotion rather than systematically

Thirdly, many traders fail to control their emotions when trading and end up ruining their hard-earned cash. For instance, after having multiple losses in a trading session, a trader is afraid of having a losing day.

This worry triggers the trader to over-leverage and blow up their trading accounts.

It can also cause FOMO. One of the most common trading emotions you will come across, which stands for fear of missing out.

This happens all the time when you see a hot stock that is ripping higher and all you want to do is buy some shares but can’t get a good entry so you end up chasing it. This usually results in a bad entry and increases the likelihood of taking losses.

  • Lack of discipline

Discipline is the most important trait of successful trading.

Lack of discipline is often the cause of the most common trading mistakes like executing trades prematurely, over-trading, revenge-trading, breaking trading rules, violating risk management rules, making impulsive trading decisions, and more.

All of these things mostly result in losing much more cash than what a trader had initially projected and what would be necessary.

What You Can Do To Realize More Success In Your TradingTo avoid both of these mistakes and become more successful, traders ought to a few important things that we’re going to discuss in the following section:

Define your trading edge

Focus on a strategy that makes sense to you and master it as opposed to trading all types of strategies.

For example, Ross focuses on small cap momentum. Basically, a small cap is a company with a market capitalization of between $300 million and $2 billion.

Ross has mastered several small-cap trading strategies and knows how to find support and resistance on charts. His trades are mostly based on small cap stocks that rise 20-30% or more in a single day. These stocks are typically priced between $2 to $10.

So, instead of trading Apple (NASDAQ: AAPL) and many of the other large cap stocks, Ross prefers to trade small cap stocks which are generally more volatile.

Review your trading process with an open mind

 As mentioned earlier, most traders never look at their trades again once they have closed them. They just jump to the next trade, forget everything they did previously, and completely avoid learning effects.

Make sure to review your trading process on a regular basis. Keep an open mind while doing so and it will show you everything you need to know.

You also have to be wary that if you are too stuck in your ways, you will end up imposing your ideas on what the market ought to do, instead of reacting to what is really happening.

Make revisions where you see weakness in your trading

Most traders do not understand why they need to revise their strategy. You need to take your trading strategy through a process of trial and error for it to be complete. While this will take time, it is effective and works perfectly with the market and increases the chance of success.

One easy way you can do this is by writing down the mistakes you make frequently and putting those physical notes next to your trading screen where they can see them at all time, so they can help you become more aware of your actions.

Always work on improving and adapting to market conditions

Having a trading strategy is not enough.

You constantly have to change your trading behavior from trade to trade in order to adapt to changing market conditions. If you don’t adapt to constantly changing market conditions, you will never be able to make decent profits in trading.

Volatility is the factor that keeps on changing and when it changes, you have to change your trading strategy too. By adjusting your trading approach and analyzing volatility accordingly, you can provide a whole new level of help to your trading strategy.

Traders have to know what to change, why to change it and when. While no trading strategy works 100% of the time, it is your responsibility to find ways to make your trading strategy work in every market condition.

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How To Draw Fibonacci Levels?

Financial Advise

If you are an active day trader, you are probably aware that Fibonacci retracement and extension levels are some of the most important and useful tools in all of price action.

Day traders and technical analysts can use Fibonacci levels analysis to confirm an entry-level, target a take profit, and to determine your stop loss level.

In this guide we will explain exactly how to draw Fibonacci levels, so that you can make better decisions about when to get in and out of trades.

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A Beginners Guide to Investment Factors

Financial Advise
Value, Momentum, Size, Low-Volatility, and Quality

Investment factors are a set of quantitative criteria used to explain investment returns.

The idea is that some baskets of securities that have similar criteria might deliver superior risk-adjusted returns. 

At its simplest, an investment factor is a characteristic of a security that is associated with superior risk-adjusted returns. That could be a low valuation, price momentum, earnings growth, insider buying, etc.

While there’s hundreds of different investment factors published in academic literature, the factors that get the most attention, have the most institutional support, and the most scalability, are value, momentum, size, low-volatility, and quality. 

Why Factor Investing?

Factor investing in many ways is a solution for investors that can’t stomach a purely passive indexing approach.

They don’t like that they’re blindly investing in hundreds of companies based on the notion that the market always goes up over time, but they’re also aware of the flaws of picking individual stocks or timing the market.

Investing in factors that make sense to the investor can be a good compromise here.

For example, you might have a strong belief in the value investing philosophy, that you should always strive to buy a business at the right price.

You could opt to invest a large portion of your equity allocation in value factor EFTs for mutual funds with the peace of mind that, even though you don’t know what you own specifically, at least you know that you own lower valuation companies. 

Essentially, a factor investment portfolio is built using simple quantitative criteria.

For value stocks it’d be ranking a universe of stocks based on a valuation metric.

For momentum, it might be a 12-month lookback at returns. Of course, factor investors optimize and have more sophisticated models, but the big ideas are simple and laid out in this article. 

The Value Factor

The value factor represents the historical tendency for stocks with low valuation to earn excess returns compared to both the overall market, and their high valuation counterparts.

How do you define a low valuation, though? A few decades ago, a 20 PE was very high, while today it’s the market average. 

This is why factor-based strategies employ a relative valuation approach.

They buy what’s cheap compared to the rest of the market, rather than setting an arbitrary hurdle rate for their investments. This prevents factor-based strategies from taking a specific macro view on what risk premiums should be or will be.

The Momentum Factor

The momentum factor refers to the tendency for recent outperforming stocks to continue their outperformance in the short-to-medium term.

You can sum this up as “buy what’s going up, sell what’s going down.” And the interesting thing is that most equity momentum models that hedge funds charge fees for are no more complex than that. 

Momentum has always been the red-headed step child when it comes to sources of returns.

Sophisticated investors look down on it and deride them as gamblers or market tourists without skill. I’d say this is more Wall Street culture than anything. Simple solutions are hard to sell because clients can implement them on their own. And most Wall Street executives are Harvard or Wharton educated, and can’t imagine a naive strategy of buying the stocks that go up would ever work. 

But, there’s substantial evidence in favor of the momentum factor providing excess returns. It’s well accepted by both academia and institutional investors alike.

The basic way that a factor-based equity momentum portfolio works is, you rank the universe based on trailing six or twelve month performance, and buy the top performers. There’s some extra algebra involved, but that’s the core essence of it.

The Quality Factor

The quality factor refers to the tendency for firms with high levels of profits to outperform unprofitable firms. Like the other factors, there’s multiple ways that factor investors might express quality, and there’s not really an agreed upon definition for “quality.”

Between ETF managers, academics, and hedge funds like AQR, everyone has their own definition of the quality factor. But there’s tons of overlap. Here are some metrics you’ll see in a lot of quality models: 

  • Return on invested capital (ROIC)
  • Return on assets (ROA)
  • Gross profits
  • Inventory turnover
  • Return on equity (ROE) 

As you could probably make out, these metrics are all screening for companies that take money and turn it into more money in an efficient and fast way, with few surprises.

One example of a quality factor model might be to use a weighted average of a few of the above metrics to prevent the risk of an anomaly in a company’s financial statements from ending up in the portfolio.

The Low-Volatility Factor

The low volatility factor refers to the tendency for boring stocks to outperform their high-flying, exciting peers in the long-term, on a risk-adjusted basis. Of all five of the major factors, low-volatility is the least explainable.

The rest makes sense and could be explained to a five-year old, “buy what goes up,” “buy the bargain bin,” “buy the top-shelf goods,” “buy the underdogs.” 

Because of the lack of explainability, there’s a higher potential that the outperformance is an anomaly or the result of data mining. The low-volatility factor flies in the face of the Capital Asset Pricing Model, which posits that investors should be compensated for taking on more risk. But, this factor says that the returns are actually higher in the lower risk assets.

Building a low-volatility portfolio would be relatively easy. You can use the stock’s N-day standard deviation, its average true range, or even it’s Beta. Then simply rank and buy the lowest volatility stocks.

Building a long/short portfolio for this factor seems like a disaster waiting to happen, though. 

The Size Factor

The size factor refers to the tendency for smaller stocks to outperform large stocks.

This is probably because with small and micro cap stocks being generally illiquid, an investor deserves a risk premium for taking on the liquidity risk.

Further, it’s much easier to double $100 million of revenue than to double $10 billion of revenue, making the potential for home runs with small stocks much higher. Also, small stocks receive very little Wall Street coverage, and most institutional investors are too big to pay attention to them, leaving alpha on the table. 

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