You are so smart. You have a great trade idea and you know it will be a winner, but there is only one small problem. For any trade you make, there has to be someone else on the other side of the trade. For every buyer, there has to be a seller. So for what you are doing right there has to be someone doing something wrong? That may not be exactly true, but any trader should work under the assumption that his smart money is taking advantage of less smart or "challenged" money. What is your advantage when you make a trade? We have looked at this before in "The three ways hedge funds make money", but I find using the acronym BAIT, developed by Michael Mauboussin in "Who is on the other side?", is a great way to describe this issue. The acronym BAIT stands for the possible advantages of a manager: Behavioral, Analytical, Informational, and Technical.
B - Behavioral - Opportunities based on the behavior of others who make mistakes that lead prices to diverge from value. If there are enough investors who engage in behavioral biases, there are opportunities for those that avoid these biases. Mr. Market can act irrationally, albeit it may be hard to know when this will occur. Taking advantage of behavioral bias still needs a sense of value. Nevertheless, behavioral biases may create patterns in prices that can be exploited.
A - Analytical -There is advantage associated with analytical skill which is the ability to interpret or weight information differently than the rest of the market. Much information is publicly available so analytical skill is the ability to use the information that is available to all in a different manner to achieve better returns. There is an advantage with the better processing and weighting of information versus others.
I - Informational - Acquiring better information is hard in the current markets. There are restrictions on the dissemination of private information, but there is new information that becomes available. An information advantage can come from speed of use and there is advantage from the use of information that is obscure. There is gain from the aggregation of new and existing information.
T- Technical - There are technical inefficiencies that arise for reasons that are unrelated to new market information. There is informationless trading such as rebalancing from additions and withdrawals that create opportunities for profit. Passive adjustments can provide liquidity or need liquidity from others. Similarly, there are changes in regulation that will lead to rebalancing that offer those unaffected by the regulation opportunities for profit. For example, new restrictive bank regulations may offer opportunities for investors that can provide investment capital. Flows based on reasons other than new information matter.
The use of BAIT is simple. When you think about taking a trade as the question what BAIT am I using to gain excess return.