Photo by Anonymous9000

Photo by Anonymous9000

OK, before someone lambasts me for switching to trading, please read and re-read the title carefully. I mentioned that “traders” are important for investing, and not “trading”. The use of the two somewhat similar-sounding words makes a whale of a difference though, and this post shall proceed to explain why, and how I can justify the above statement.

In any stock market, there always exists an abundance of traders/speculators while there are usually only a handful of investors. The investors sit on their butts and wait patiently for their shares to reach their perceived fair value, all the while exercising patience and engaging in detailed due diligence to ensure all is moving right. By contrast, the active traders are the one who zip around like dragonflies on a hot noon day, flitting from counter to counter in the hopes of entering and exiting with maximum profit (and minimum loss). There exists a certain relationship between the two camps – one whereby each takes advantage of the other’s actions to generate opportunities to make money. Let’s take it from the point of view of the investors, first.

Investors have the unenviable job of researching, reading and analysing company fundamentals, and waiting for margin of safety to appear when Mr. Market presents it. Traders help to accelerate this process by 1) creating liquidity and also 2) creating instances where mis-pricing is so evident that investors will be “forced” to react. These two factors alone are pertinent reasons for the importance of traders to the investing process. Liquidity can be seen as the oil which greases the wheels of the stock market, and it is important when an investor wishes to take a position in a company which he feels offers long-term investment potential AND a margin of safety. However, it is well-known that illiquidity in some counters creates wide bid-ask spreads, and this can severely hamper an investor’s ability to purchase a significant stake in a company at a low enough price due to the illiquidity premium, and also the prohibitive bid-ask spread which results in higher fees. Traders are responsible for providing much-needed liquidity, so that an investor can find the volume to purchase a sizeable stake, and also to avoid the associated higher costs which come from a wide bid-ask spread. Read more…