Posted on 02/02/2005 3:32:08 AM PST by snarks_when_bored
'Zero intelligence' trading closely mimics stock market
11:59 01 February 2005
NewScientist.com news service
Katharine Davis
A model that assumes stock market traders have zero intelligence has been found to mimic the behaviour of the London Stock Exchange very closely.
However, the surprising result does not mean traders are actually just buying and selling at random, say researchers. Instead, it suggests that the movement of markets depend less on the strategic behaviour of traders and more on the structure and constraints of the trading system itself.
The research, led by J Doyne Farmer and his colleagues at the Santa Fe Institute, New Mexico, US, say the finding could be used to identify ways to lower volatility in the stock markets and reduce transaction costs, both of which would benefit small investors and perhaps bigger investors too.
A spokesperson for the London Stock Exchange says: "It's an interesting bit of work that mirrors things we're looking at ourselves."
Most models of financial markets start with the assumption that traders act rationally and have access to all the information they need. The models are then tweaked to take into account that these assumptions are not always entirely true.
But Farmer and his colleagues took a different approach. "We begin with random agents," he says. "The model was idealised, but nonetheless we still thought it might match some of the properties of real markets."
In the model, agents with zero intelligence place random orders to buy and sell stocks at a given price. If an order to sell is lower than the highest buy price in the system, the transaction will take place and the order will be removed - a market order. If the sell order is higher than the highest buy price, it will stay in the system until a matching buy order is found - a limit order. For example, if the highest order to buy a stock is $10, limit orders to sell will be above $10 and market orders to sell will be below $10.
The team used the model to examine two important characteristics of financial markets. These were the spread - the price difference between the best buy and sell limit orders - and the price diffusion rate - a standard measure of risk that looks at how quickly the price changes and by how much.
The model was tested against London Stock Exchange data on 11 real stocks collected over 21 months - 6 million buy and sell orders. It predicted 96% of the spread variance and 76% of the variance in the price diffusion rate. The model also showed that increasing the number of market orders increased price volatility because there are then fewer limit orders to match up with each other.
The observation could be useful in the real financial markets. "If it is considered socially desirable to lower volatility, this can be done by giving incentives for people who place limit orders, and charging the people who place market orders," Farmer says.
Some amount of volatility is important, because prices should reflect any new information, but many observers believe there is more volatility than there should be. "On one day the prices of US stock dropped 20% on no apparent news," says Farmer. "High volatility makes people jittery and sours the investment climate." It also creates a high spread, which can make it more expensive to trade in shares.
The London Stock Exchange already has a charging structure in place that encourages limit orders. "Limit orders are a good way for smaller investors to trade on the order book," says a spokesperson.
Journal reference: Proceedings of the National Academy of Sciences (DOI: 10.1073/pnas.0409157102)
'The market knows best' is another way of saying that 'the market knows nothing'?
Oh, my.
BTW, application of a similar analysis to an area of intense current controversy on FR is left as an exercise for the reader.
Ping
Well, maybe it is to be interpreted as limited intelligences of different traders effectively canceling one another? Peter Lynch, after all, happens once in a generation. To systematically beat the market returns is given to VERY few.
The Constitution only gives Congress the authority to levy taxes to raise revenue, not to regulate stock trading.
How then can you explain the volatility of prices when the market's are closed? My point is that I don't think your solution would work. In fact it would raise the cost of doing business and therefore might increase realized volatility.
(I've been working in quantitative market research for 17 years so if you're going to answer, please feel free to be as specific as you like. I've read all the latest work by everyone taken seriously so you won't be too far ahead of me.)
b
" Are you under the mistaken assumptions that volatility is caused by the number of transactions? "
Darn good question! Actually, I'm not sure what causes volatility. However, I strongly suspect it is from large numbers of people all thinking they are smarter about markets than most other people when actually they are about average. This results in the huge market volumes we see today when coupled with computers.
What is your idea concerning the cause of volatility? I like to consider everything when it comes to markets.
I am not addressing the volatility, but when's the market really closed? You have after hours trading (ie, Instinet, etc), foreign markets are open, etc.
If everyone instantly knew everything about the markets then there would be no volatility at all. Every time a new piece of information were revealed it's impact would be instantly known, and the assets effected by it would all instantly be revalued. All markets would look like a chart of Chinese currency prices with long flat patches interrupted by momentary revaluations. So in effect it is the cost of doing business (or to quote Thomas Sowell the "Cost of Information") which allows for diversity of opinion among investors and thereby contributes to volatility.
But in some respects it is caused by people who think they are smarter than the market. There is a concept called an "Information cascade" which my current work is focused on. This is a big contributor to market vol in my opinion.
Either way however, a 'transaction tax' wouldn't lower volatility, and in fact might actually amplify it. I'm also at a loss to see how a transaction tax might have prevented the long term capital issue which was caused by a credit contraction not by volatility. But I'm open to hearing explanations.
I can tell you. Market volatility is caused by traders buying high and selling low. They do this when they bought with either erroneous information, or inadequate smarts. In this wonderful information age erroneous info can be more and more easily rechecked. OTOH, inadequate smarts is either solved by the de-incentive of loosing money, or (in the case of really dumb buyers) going broke and going back to work as financial advisors.
These problems are both solving themselves and don't need an omnipotent government solution of (as usual) more taxes. Buy looking at fluctuations over the long term and more recent times, the trend is toward less and less volitility.
All this is pretty much argument by definition. Then again, if you don't agree with my take I interested in your thoughts.
As to your other question, if you raise the cost of a transaction, you haven't prevented the value of the asset from changing, you've only raised the threshold that short term traders need to make a profit. If a bid offer spread is .1 and a .1 tax is added to each transaction, the spread will change quickly to .15 or so depending on how the market organically decides to address the disposition of the tax. So now instead of each change in price being between the bid offer spread being .1 points apart, They will be .15 points apart...which is more volatile than before.
This concept translates into longer time frames as well, but it's a little more complicated to explain. The cumulative cost of information is a big part of why 2 different people can look at the same asset at the same time with the same information and think it should have 2 different values. If you increase the cost of information, you increase only that difference. In the end, that difference of opinion, or lack of consensus is what leads to volatility.
I don't mean to imply that it's a phenomenon with a single cause because it isn't. Many things effect the change in consensus strength at a particular time, but it's certainly a contributor.
the best thing to do to reduce volatility is to find a way to make the markets more efficient. Adding a tax does the opposite.
It's a good idea, it's just wrong. I'll take an analyst with a bunch of crazy ideas that don't work in a second over one with no ideas at all.
As to makeing the markets more efficienct, I've found that focusing on making a buck is about as much nobility as I can handle.
Website? You might be mistaking me for someone else.
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