I watched Wall Street (1987) for the fourth or fifth time a few days ago and figured this has to be my favourite scene. There are soo many good sound bites in this scene. My favourite is probably

It’s a zero sum game. Somebody wins, somebody loses. Money itself isn’t lost or made, it’s simply transferred from one perception to another. Like magic!

along with the epic

I create nothing, I own.

This movie should be a homework assignment for all economics, finance, or business students out there. I learnt more about financial markets from it than I did from any financial markets textbook.

Presented by John T. Harvey in Currencies, Capital Flows and Crises: A post Keynesian analysis of exchange rate determination this simple model covers pretty much all there is to know about fundamental analysis in foreign exchange markets. It lacks any real computational power, sure, but that’s not its main purpose. The purpose of this model is to showcase the main elements found behind foreign exchange price action and the relationship between these elements. I’m sure way too many retail traders have no idea about these mechanisms (just like I didn’t know anything about them a couple of years ago when I was still starting out and was thinking that there’s so much predictive power behind the MACD indicator that I’ll never need anything else to get rich) and I’m sure learning about them would help many. I’d present more about it but I suggest you go check out the book.

I know the following quote looks like it’s coming from the Federal Reserve Act but I promise you that is not the case. The quote actually comes from the official Monopoly game rules. In the section titled “The Bank” there’s the following:

The Bank “never goes broke.” If the Bank runs out of money, the Banker may issue as much as needed by writing on any ordinary paper.

I actually had to double check the list of FOMC members to see if Rich Uncle Moneybags was among them. It seems he’s not. He’d make a great central banker though.

Expectations

It’s all about expectations. Few people trade the economic numbers. Most people trade what they think the market expects the economic numbers to be. And for good reasons.

Since portfolio capital flows dominate the foreign exchange market it can be said that it is today’s expectations of future price movements that play the most important role in determining the current foreign exchange rate. Agents are not, as in rational expectations, forecasting an event that is independent of their actions – they are creating the event. Realized outcomes clearly affect the exchange rate but even then the current structure of the currency market means that they do so primarily through expectations. The dollar moves more in reaction to the announcement of a trade imbalance rather than from the pressures created by the imbalance itself.

Soros has some good stuff on expectations and how they shape perceptions, market prices, and ultimately even fundamentals in his theory of reflexivity. Will probably extract some stuff from there as well in some future posts.

Keynes has a famous example which underlines how expectations drive the markets and how a trader’s job is not necessarily about predicting what the true fundamental value is, nor is it about predicting what the market thinks the true fundamental value is, but rather about predicting what the market thinks the market thinks. I’m talking about Keynes’ beauty contest. It sounds funny and/or convoluted but it’s rather true.

professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.

Heuristics and other tendencies

With availability, which is used to estimate frequency (in the past) or likelihood (in the future) the more available something is in memory (either through imagination or recalling pas instances) the more frequent or likely that event is deemed.

In forecasting, traders may overrate the importance of events that were more recent or dramatic or fit preconceptions.

Representativeness is used when one is concerned with the probability that object A belongs to class B. The more A resembles B, so the heuristic goes, the more likely that it belongs to class B. The series of coin tosses T-H-T-H-T may be deemed more likely the outcome of a random coin toss than T-T-T-T-H because the former better represents randomness.

In the markets, representativeness means that traders expect every currency movement to have a very specific cause, whether they can discern it or not. As Keynes put it, because our knowledge of the future is “vague and scanty” the information of which we are aware plays a disproportionate role in our forecasts.

Anchoring occurs when the individual must make a forecast. When this is done by starting at some initial estimate and then adjusting, people tend to anchor to that first value regardless of the process used to generate it.

Since most of the time, the most recent time series inform the current forecast, traders, especially technical traders, will tend to anchor to levels in calm markets and to rates of change in volatile ones.

Except Keynes’ beauty contest example, all quotes come from Currencies, Capital Flows and Crises: A Post Keynesian Analysis of Exchange Rate Determination. It’s a rather small economics book written by an academic that addresses the foreign exchange markets from the perspective of a practitioner rather than that of a close minded impractical academic. It presents economics stuff that is rather useful.

The quotes below come from Trading and Exchanges: Market Microstructure for Practitioners. Emphasis belongs to me. Some quotes have been edited.

I first read this book quite a while ago, but I started reading it again today after running into it in a casual library browsing. I believe the book is a great introduction to financial markets for anyone who is looking to get started in this field. It won’t teach you how to make money but it will teach you all the things you absolutely need to know before you can raise any profit pretensions.

I will probably be posting more of these in the following couple of days.

Speculators

This is the category you want to be in and probably already think you’re in. But are you?

Speculators are trades who use information to predict future price changes more accurately than most other traders can. Their superior information gives them an advantage when they trade. Speculators trade because they expect to make money. Depending on what they know they may trade in betting markets or in financial markets.

I mean, sure, everybody expects to make money. But why would you expect such a thing? Do you really have superior information?

Gamblers

Gamblers are different from speculators. In contrast, gamblers are uninformed traders. Although they hope to make money, they have no rational reason to expect that they will do so. Gamblers who are honest with themselves trade for entertainment. Gamblers who trade because they believe that they will be successful speculators are foolish.

And how many gamblers who are honest with themselves do you know?

Many – probably most – traders who gamble in the financial markets are unaware that they are gambling. Most believe that they are pursuing other objectives. Traders need great discipline to discriminate between prudent risk-taking behavior and gambling. Many traders who believe that they are speculating actually are gambling because they do not recognize that the information upon which they trade does not give them any advantage over other traders. Traders who gamble can sometimes be identified by their enthusiasm for trading and by their inability to clearly articulate their reasons for trading.

Most retail traders fall into this category. They trade overused chart patters, old news, or irrelevant trading systems.

Gambling is not necessarily bad for financial markets. Since gamblers are uninformed traders they tend to lose to well-informed traders. When many gamblers are present, informed trading can be quite profitable.

Sharks are always happy to welcome new fish.

Fledglings

Fledglings trade to learn whether they can trade profitably. They are willing to lose money when trading to answer this question.

Since measuring performance can be very difficult fledglings may falsely conclude that they are skilled when they are only lucky. A lucky, but unskilled fledgling is still a fledgling. Many successful traders, including professional portfolio managers, may still be fledglings. Success does not necessarily imply skill.

Success does not necessarily imply skill. Make sure to remember that.

Do you recognize yourself as belonging to one of these categories? Do you recognize others as belonging to one of them? Do you recognize yourself as having once belonged to one of these categories?