Opportunity Cost Differentials: Another Example
Let us suppose we faced a pure arbitrage situation. There is a deal that is 100% certain to close (or as near to that as we can get). The only question for the investor is whether to hold the position until the deal is paid off, or to accept current prices and move on to a new trade.
The answer varies with the investor! It depends upon what alternative opportunities have been presented, and perhaps even on the interest rates they have negotiated with their banks. It may be quite correct for one party to sell and another to buy, the position moving to the party with the lowest opportunity cost, and (perhaps) a higher risk tolerance.
Time Frames: Another Example
The most difficult application relates to time frames. Let us suppose that you were asked to make a single investment decision right now. You were not allowed to change your position (unrealistic, but bear with the example for the moment).
The question is whether to buy the S&P 500. You will be judged over the following seven time frames:
- One minute
- One hour
- One day
- One week
- One month
- Six months
- One year
In practice, anyone can and should change opinions with the circumstances and facts. Having said this, at any moment the answer might be different depending on the time frame.
My colleagues at RealMoney make a lot of market forecasts. Sometimes their disagreements are not really about the fundamentals of the market, but about time frames. Today, for example, Doug Kass was bullish in the short term and more bearish for the intermediate term. He has even instituted a quantitative rating system, a nice touch. As regular readers know, we have great interest in his trading calls, especially when he sees a bullish signal. Bob Marcin, another of our favorite commentators turned more bearish. After some discussion, (subscription required for all of it) Bob wrote as follows:
Clearly we have different definitions of time frames. This is an intermediate call and that means the next 6-9 months. My definition of short term is less than 3 months, but not daily. You go all in and reverse in a day. We might be more on the same page than you think.
The key point is that both may be making an accurate prediction, given their respective time frames.
Our Take
Time frames are absolutely crucial. Our own market view is bullish over the rest of the year, but bearish for the next month, based on our TCA system. We do not make major adjustments in long-term accounts based upon our one-month forecasts, but we use it for "leans" and entries and exits. We occasionally make intra-day trades when circumstances warrant.
The Result
Two parties can make a trade based upon different time frames, and both can be correct. Even a single investor using multiple models may get conflicting signals.
The success of a strategy should be evaluated based upon the specified time frame, the acceptable risk, and other factors.
An Interesting Question
Much of the trading volume is now based upon systems where trading success is measured in minutes or even seconds. Monday's volume was about 25% lower than expected, widely attributed to the exciting conclusion to the U.S. Open playoff. This means that many traders left money on the table by watching golf instead of implementing their normal strategies.
What was the opportunity cost of the golf tournament?
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