Wednesday, October 27, 2010

The dilemma of market prices and Information Theory

Can information theory help us better understand market price behavior? Information theory states that an unexpected event or signal that occurs contains more informational content than an event that is expected. I can follow the logic of this. But here is the dilemma; if a signal or an event contains more information, it theoretically should reduce uncertainty.

When the market receives unexpected news, prices immediately react, but the sudden reaction in prices does not generally reduce uncertainty, it increases it. In my opinion, given everything else, if the news has been expected, one should expect market prices to be range bound with negative feedback dominating price moves. But if the news is unexpected, then a price breakout in some direction usually occurs. Price breakouts are positive feedback events that generally create herdlike trading. Although the unexpected news event may contain more information, it does not necessarily lessen uncertainty, it increases it. This can lead to trading opportunities for discretionary style traders.

I have difficulty understanding how discretionary traders can make money on a consistent basis. Discretionary traders not only have to figure out what direction prices are going to move, but they also have to determine if the news is expected or unexpected. This is why we see the market move so much when economic figures or earnings are released that differ from the consensus opinion. Consensus is synonymous with expected. Relating the actual figure to the consensus number is another aspect that a discretionary trader has to take into account. Then, if that is not hard enough, the discretionary trader has to figure how far and in what timeframe prices will move. Is it not better to trade the market systematically? I think so.

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