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# System prepended metadata

title: Three Fuzzy Questions of Trading
tags: [invest]

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###### tags: `invest`
# Three Fuzzy Questions of Trading
### Introduction

To survive and profit in financial market trading in the long run, it is necessary to **achieve a more accurate pricing of the risk-return ratio than the market** and then trade based on the risk-return ratio. The so-called "pricing" often only pursues fuzzy correctness, and obsessing over precise pricing only wastes time on finding errors. Specifically, at the trading level, a profitable trade requires a fuzzy and correct answer to the following three questions:

1. Do I have a correct understanding of the target asset?
2. Does the market have a mistaken understanding of the target asset?
3. How long will the market take to correct its mistakes, and can my position survive?

The cognitive differences between questions one and two lead to differences in pricing of the investment target. These pricing differences can infer potential profits and risks, namely the Risk Return ratio, which is the essence of an excellent investor's or trader's alpha source. Question three can be used to measure whether the return on investment during a certain time period meets personal pursuit, as well as to assist in improving position survival ability. The first two questions are the key issues that require the most researchs investment in trading. Answering these two questions is extremely difficult in most fields, and even investing years of effort in learning and expanding one's [circle of competence](https://en.wikipedia.org/wiki/Circle_of_competence) may not lead to a clear answer. **Therefore, it is wisdom to recognize the limitations of one's own knowledge and give up on certain topics.**

### Do I have a correct understanding of the target asset?

When we talk about "correct understanding," we are actually pursuing the future free cash flow growth of the investment target, but in reality, the target asset **can only obtain more free cash flow from the world if it has better bargaining power (same as individuals).** To understand bargaining power (and its changes), we need a deep understanding of specific business, competition, and human nature.

- Do we have have true and comprehensive information? Or at least fair information situation?
    - First, judge the information asymmetry before discussing the correct understanding: it is difficult to gain an advantage in understanding when there is a significant gap in information quality.
    - How to judge our position in information acquisition? When communicating with other investors with pricing power, most of the factual information is already known.
- Two underlying elements to achieve a correct understanding: continuous learning (changing world) and respect for human nature (unchanging things).
- Does the understanding respect common sense, human nature, and business logic?
- Constantly consider one's own limitations and think from the opposite perspective of one's own views.

### Does the market have a mistaken understanding of the target asset?

The main purpose of understanding the market is to identify the core factors that affect the price. When the market trades on a wrong view, we hold the opposite correct view, and the market eventually corrects its mistake to achieve investment alpha.

Where to get market information?

- Consider the authenticity of market information, as higher-cost information typically has higher authenticity.
- Different people have different ways of obtaining information: on-chain information, expert/investor interviews, social media, insider information.
- Price trends and trading volume represent the most important market views, and price and volume are often low-cost and high-authenticity information that ordinary people can get.
- Large-cap targets need to avoid information sources bias, such as views from a few investors. Social media is a better source.
- Small-cap targets often have few sources of market information and need to get true information through core investors that have pricing power.

Understanding and comprehending the market can be approached from the perspectives of three types of people, helping to understand why the market is currently priced the way it is? How it may be priced in the future? It can also help identify disagreements with the market.

- Holders: What are the development and profit expectations? What is the valuation logic? What is the level of risk appetite? Where are the risks?
- Non-holders who pay attention to target asset: What are the core reasons for not holding? What changes would lead to buying or adding positions?
- People who do not pay attention: Why are they not paying attention? Would they consider buying after paying attention? Sometimes incorrect pricing occurs simply because something is not being followed.
- From the perspective of holders, figure out the risks. From the perspective of non-holders, figure out the profit potential.

Other key points in market understanding:

- When prices fluctuate significantly, it is often easier to identify what the market is trading.
- The market makes mistakes less often. When you think the market is wrong, try to think from the opposite perspective.
- Linear extrapolation is a major source of financial market errors.
- Think more about what risks are not priced in by the market, which can help better understand the downside.

### How long will the market take to correct its mistaken understanding, and can my position survive?

Why consider how long the market takes to correct its wrong understanding? The reason is that we are pursuing annualized returns, and the time dimension is related to the word "annualized."

- Why does the market make pricing mistakes? The time required to correct different reasons for erroneous pricing is not the same. For example, panic, low attention, bias.
- What will be the catalyst for correcting mistakes? For example, turning losses into profits, increasing buybacks, and increasing dividends.

**When do we need to consider whether a position can survive?**

When holding assets without debt, there is no need to consider the survival of the position, and fluctuations will not cause the position to collapse. However, if debt factors are introduced, such as leverage or shorting asset, whether the position can survive under fluctuations becomes a factor that must be considered.

- One of the fundamental element of volatility is liquidity.
    - Most of the time, liquidity is abundant, but there may be a shortage of liquidity during extreme panic and optimism. Can the position survive in extreme situations?
    - Are the chips highly concentrated in a few people? What is the difficulty, cost, and cost-effectiveness of their influence on prices?