Exploring the Nature of “Trader Intuition”

Abstract

Experimental evidence has consistently confirmed the ability of uninformed traders, even novices, to infer information from the trading process. After contrasting brain activation in subjects watching markets with and without insiders, we hypothesize that Theory of Mind (ToM) helps explain this pattern, where ToM refers to the human capacity to discern malicious or benevolent intent. We find that skill in predicting price changes in markets with insiders correlates with scores on two ToM tests. We document GARCH-like persistence in transaction price changes that may help investors read markets when there are insiders. THIS PAPER REPORTS RESULTS FROM EXPERIMENTS meant to explore how uninformed traders read information from transaction prices and order flow in financial markets with insiders. Since the seminal experiments of Charles Plott and Shyam Sunder in the early 1980s (Plott and Sunder (1988)), it has been repeatedly confirmed (as we will do here too) that uninformed traders are quite capable of quickly inferring the signals that informed traders (insiders) have about future dividends, despite anonymity of the trading process, despite a lack of structural knowledge of the situation, and despite the absence of long histories from which they can learn the market's statistical regularities.It is striking that so little is understood about the ability of the uninformed to infer the signals of others. This ability constitutes the basis of the efficient markets hypothesis (Fama (1991)), EMH, which states that prices fully reflect all available information. Underlying EMH are the ideas that the uninformed will trade on the signals they manage to infer, and that, through the orders of the uninformed, these signals are effectively amplified in the price formation process. In the extreme, prices will fully reflect all available information. However, without a better understanding of how the uninformed read * Bruguier, Quartz, and Bossaerts are at the California Institute of Technology, and Bossaerts is also at the Ecole Polytechnique Fédérale Lausanne.

On the persistence of strategic sophistication

“…See Figure 5 for sample problems. Poor performance on this task is diagnostic of high-functioning adult autism or Asperger's Syndrome [7] and strong performance is correlated with the ability to determine whether or not price movements in a market are affected by a trader with inside information [13].…”

“…For each level k > 0 the Level-k strategy σ k i ∈ ∆(S i ) for player i with k i (γ, τ i ) = k is a best response to beliefs ν(k), given that each level κ < k of player j plays σ κ j . 13 Formally, for each k > 0, (i believes j believes his opponent's levels follow this distribution, et cetera). Strzalecki [64] builds a similarthough more general-type-space model that encompasses all Level-k models.…”

“…This second interpretation does suggest that ν(k i )(0) should be positive for all k i , which is inconsistent with the commonly-used assumption that ν(k i )(k i − 1) = 1 for all k i . 13 If there are multiple pure-strategy best responses then σ κ i can be any distribution over those best responses, and that distribution is assumed to be known by all higher levels. the strategy σ k i is such that for all…”

Intuition, expertise and emotion in the decision making of investment bank traders

“…They posit that financial markets are occupied by insiders (those with advance knowledge of information that can effect stock prices, e.g., managers of the firm in question) and uninformed traders (those who depend on cognitive and affective abilities to interpret market data to reach decisions). Bruguier et al (2010) argued that in the process of decision making, traders could not totally rely on information and data as by the time they reach a decision based on information available in the open market, they might have lost the advantage that they could gain from a speculative decision. Thus, Bruguier et al (2010) suspected a role of non-conscious brain processes that traders employ to interpret cues in the environment.…”

“…These features are characteristic of traders' decision making. Bruguier et al (2010) attempted to understand the role that intuition and nonconscious processes play in traders' decision making through a series of functional magnetic resonance imaging (fMRI) and other related experiments. They posit that financial markets are occupied by insiders (those with advance knowledge of information that can effect stock prices, e.g., managers of the firm in question) and uninformed traders (those who depend on cognitive and affective abilities to interpret market data to reach decisions).…”