This post is a continuation from the first post in this series, and the last post can be found here. In that first post, I suggested a set of books to build a good foundation for market knowledge. Most of those topics were foundational, somewhat abstract, and removed from actual trading. In this post, I want to move one step closer to application. The focus now shifts to market microstructure, the long history of equity and debt markets, and the basic concepts of economics and valuation.
Market microstructure: If there is one book, in my mind, that separates serious retail and aspiring professional traders from all the rest it is Trading and Exchanges: Market Microstructure for Practitioners – Larry Harris. This book should be required reading before a trader places his first trade. There is no other book that covers all of these topics so thoroughly and in one place: the marketplace (exchanges, ECN’s, etc.), the regulatory environment, types of traders, types of orders—everything having to do with the structure of the market is here. You will also be surprised to find this a very readable and accessible book. At the risk of repeating myself, if there is one book retail traders should be reading that they probably have not, it is this book.
Market history: Sadly, in most technical analysis literature, what passes for history is a list of people who wrote books before Edwards and Magee. Triumph of the Optimists: 101 Years of Global Investment Returns – Dimson, Marsh and Staunton will give you a much better perspective and understanding of what has happened in global markets in the last century. This book is an absolute must-read for any serious trader, but it is probably best absorbed in small pieces. This book is also a treasure trove of ideas and directions for further research.
Economics: Recommendations for books on Economics are probably more likely to generate dissension and controversy than any other subject on this list. You should be comfortable with micro-economics and understand the major schools of thought: Keynesian, the Chicago school and the Austrian school. The Austrian school, in particular, is more than a little out of vogue, but it is very relevant to traders and to people who would seek to understand markets and the price discovery process. There are so many fallacies and outright falsehoods, both in the major media and on blogs. Many of the self-proclaimed pundits have a C+ understanding (at best) of the basics of the subject; everyone involved in markets should educate herself in basic Economics. I don’t want to make this a political debate, but I would suggest that a productive reading list might begin with: Economics in One Lesson – Hazlitt, The Economic Way of Thinking – Heyne, and Economics for Real People – Callahan, especially if you are unfamiliar with the Austrian school. Mankiw’s books (Principles of Economics, if you are going to use just one) are also thorough and less controversial references. (Note that professor Mankiw also maintains an excellent blog that you might want to add to your reading list.)
Valuation: Once you have the basic language of Finance and Accounting, you can understand valuation. (The corollary, that you can’t understand valuation without understanding basic Finance and Accounting is also true.) I would probably start by going cover to cover through Investment Valuation: Tools and Techniques for Determining the Value of Any Asset – Aswath Damodaran. There are many good books; this one is accessible and thorough, but if you have another favorite, use it. Valuation matters. You do not have to build DCF models (though, you should be able to. Why not?) but, once again, you must be able to speak the language. If you do not understand modeling, how will you understand the impact of changing margins or interest rates on valuation? (As a test, assume that the Treasury rate is currently 1.5% and increases next year to 8%. All other things being equal, what effect will that have on Equity valuations? If you don’t know why this question is here, read a book on valuation.) Too many traders make half-baked assessments based on an incomplete understanding of these factors. Even if you are a short-term trader, the people making longer-term decisions that move markets are making those decisions based on their understanding and estimation of value. A common argument from traders is that valuation isn’t relevant because prices often diverge from true value. This may or may not be true (not having that debate here), but if you don’t understand valuation, how will you know when prices have diverged?
In the next, and last, post in this series I will get to some trading-specific books.