Zero intelligence trading

Discussion in 'Wall St. News' started by PuffyGums, Aug 15, 2005.

  1. I saw the title of this article and though of ET.

    'Zero intelligence' trading closely mimics stock market
    11:59 01 February 2005 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."

    Buying and selling

    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.

    Incentives and charges

    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.
  2. And here I thought someone had written my biography!

  3. Or maybe read Larry Harris ch's 10, 14 and 16.

    Sorry I couldn't resist acing Nitro yet once again.

    Does Jim Cochrane still post occasionally? If so, tell Larry.
  4. Mvic


    Not surprsingly limit orders also make the spacialists job a lot easier and increas his ability to make a profit.

    The flaw in the piece is that it does not account for the fact that a small group of traders are consistantly successful and the rest aren't, unless the conclusion is that amongst the universe of market participants the traders are relatively insignificant.
  5. Don't worry inandlog, as long as you keep on making money!
    Talking about intelligence in markets is for rascals.
  6. "High volatility makes people jittery and sours the investment climate."

    These guys think that traders trade with a 'sombrero' during a hot 'siesta'.
  7. Totally unrelated, but was on the "Breaking news" section of the link posted above...

    Guess this puts a new meaning to "man, that is piss-weak"... :D
    ...or "I'm just going to recharge the battery..." :p
    ... or "I need to carry a few Bees with me, because mine runs only on BP!!!" Badaboom!
  8. Here's an opposing arguement that Limit orders cause volitility:

    Consider, that if there were no Limit orders and all the orders out there were market orders, then price would just stay where it is, bouncing between the bid and ask.

    Alternatively, if you have one market order Buy, and one Limit order Sell that's 50 points higher than the market order, then price will jump that 50 points to meet the Limit order. Hence, it was the Limit order that caused the volitility.
  9. Who the heck wants to reduce volatility?