[Homestead] The zero intelligence stock traders

tvoivozhd tvoivozd at infionline.net
Fri Feb 4 07:08:44 EST 2005

Damned few Warren Buffets around---who only invests in stocks he 
thoroughly understands, and in companies with competent 
management---with long-term objectives, not the next-quarter types.

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 

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.

Journal reference: Proceedings of the National Academy of Sciences (DOI: 

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