A convenient way of thinking about trading

Most people believe that in order to be successful in business, you have to be profitable, and for the most part they’d be right.  The primary “goal” is quite easy to measure – are you profitable or are you not? If you talk to any salesperson or sit through any company sales pitch, however, you may hear a different depiction of what businesses are. Namely they are “problem solvers”.

Whichever way you characterize it, businesses exist to supply products or services for those that demand (either want or need) particular products and services. It is helpful to point this out because if you decide you want to trade, it is much more practical to think of trading as one would if they were opening/operating their own business.   If you were to think of stock trading as a business you might start to ask:  what type of business am I? Who are my customers?  Who are my competitors?  Who are my collaborators? What kind of market is there for my product/service?  If you are trading a stock, though, what “problem” are you solving?

One very useful way to think about trading stocks is by way of an analogy with a convenience store.    The convenience store is in the business of having everyday items available in a convenient location.  Customers usually pay a bit of a premium for the “convenience” of not having to go out of their way to get the desired item. As a stock trader or investor, you are a convenient source of an item (stocks) that may be in demand. You solve the problem of inconvenient access to a stock for a buyer or seller.

An inconvenient challenge

Let’s dive a bit deeper into the convenience store analogy. A typical convenience store doesn’t have a whole lot of room,  so the store owner has to figure out exactly what to put in the store, how much of it and what to charge so that he/she can stay  in business or even be profitable.  Overcoming the big challenges of what to sell, how much and at what price are the same challenges every trader faces when looking for a profit.

Getting the right mix of things is a challenge.  For example, a lot of people may buy milk from a convenience store so naturally it makes sense for a store owner to have milk in their store.  If the store owner stocks too much milk however, there will be excess inventory that eventually could spoil and the owner could lose money. Too little milk and people will be coming into the store and leaving empty handed in which case the owner misses out on sales.

A convenience store can’t rely on milk alone though, so other items such as snacks, drinks, magazines, candy, hula hoops or whatever else they believe customers will buy make it in there.  Because store owners can’t know for sure exactly what customers will buy, nor do they know exactly what customers will be willing to pay, they have to make a guess (i.e. take a calculated risk).

The next time you look at a price tag don’t be fooled – that price is just a good guess as to what you (the buyer) is willing to pay.   This leads to an interesting question – what if they guess wrong? The answer is simple – the merchant loses money.  If they have too much milk and realize they may not sell it on time, they can lower the price (i.e. put it on super sale) and their odds of cutting their losses get better. Of course the market for milk is very “liquid” (pun intended) meaning that there are lot of people who would likely be willing to buy milk.  Hula hoops, on the other hand, may not be such a hot ticket item. If they buy a hula hoop and nobody else wants to buy it from them, then the merchant is stuck with it.

Once a merchant figures out “what” he/she wants to put on the shelves, the next question is where they get the merchandise from. Probably from a much larger wholesaler, like Costco, who has much better pricing power and can buy in bulk at a discount. The merchant has to go out to a marketplace of some sort and try to get the best price on that milk or those hula hoops so they can make the most money when they sell it to one of their customers.

So what does this have to do with stock trading? Like the store owner, most traders are small (think corner store vs. Costco) and so the amount of “inventory” (in this case stocks) they keep are also going to be small.  The “inventory” for a trader is also known as a “portfolio”.  What you keep in your portfolio you hope to eventually sell for a profit.  Unlike milk, most stocks don’t taste good on cereal nor do they really have a time limit (although options do!) but like the convenience store owner, you want to put things in your portfolio that are going to make you money.

An important question to ask yourself is: What’s the point of keeping something in your inventory that isn’t going to make you money, or worse, that is depreciating in value (think of all those stores that used to rent movies!)? So, like a savvy store owner, you have to keep your eye on what it is that your customers want but at the end of the day it’s just as much of a guess as to what people will buy and at what price.

If you buy a stock and nobody else wants to buy it from you, how much is that stock effectively worth? The answer is nothing, zip, zero and zilch. If you have one hula hoop it may not be so bad, but if you somehow bought thousands of them, well then that could spell disaster for your portfolio/store.  The lesson – buy what you believe will sell , make sure your assumptions are sound and plan for the scenario in which you’re wrong before considering a purchase.

And just who is your customer anyway? In today’s world of electronic trading, the “person” or entity that you may sell your shares to could be a bank, trading firm, or retail investor/trader. This is where the “convenience store” analogy gets a little, well, inconvenient.

Unlike a real convenience store where somebody buys milk to consume it and pays the owner for the convenience of having it available, you can’t really ‘consume’ the stock. If someone comes into the store, sees the milk at a discount to market value and decides they can resell that milk at a quick profit – then that is most definitely a savvy trader.

Believe it or not

In the world of the stock market, your “customer”, regardless of who they actually may be, is buying for the same reason you probably bought your item originally, because they believe the price will go up and they can sell it to someone else for a profit at some point in the future .

Whatever is driving that belief – be it an insider tip, a great sales pitch or a delusional fantasy of riches – it is critical that there be a belief (aka a “guess”) that prices will go higher at some point in the future. A very important question to keep in mind is if an owner of a stock believes it is going to go up in price why would you they sell it to you?  What is it that they know that you don’t or vice versa?  That question makes more than just convenient food for thought; that’s exactly what makes a market.