When a problem appears intractable, sometimes it is a good idea to step back to see the forest for the trees. To do this however may require us to suspend our beliefs, forget what we know and simply observe. The simple act of observation allows us to see the flow of it all and jump on board without having to necessarily understand the riddle. Our only prerequisite is that we take steps to help to limit our risk exposure if that ‘flow changes’.
Financial markets, like any complex system are comprised of fundamental seeds being the simple transactions of value between participants which are sufficient when the number and scale of participants increase for complexity to take hold and create magnificent but ephemeral emergent structures and a market endowed with a life of its own.
The video below takes a brief road trip into complex systems.
So let’s break a financial market down.
A market simply comprises people or their creations (algortihms) that come together to transact value. The transaction event is the simple seed of the market. There are only two times that participants interact in a market for every trade decision. The entry and the exit. At these two points the event is where information associated with the decision to interact is transferred to the market. Between these two events you are subject to the whims of other participants.
These transaction events consolidate into either random features (no collective impact on overall form aka noise or higher entropy) or non-random features ( collective impact on overall form aka order or lower entropy) derived from summating these interactions and can either be abrupt in nature or sustained over a period of time. This is not an either or statement. Both randomness and non-randomness co-exist but when one outweighs the other we get bias…or drift leading to a degree of collective form in the price series.
An enduring edge is derived from our ability to identify and act on the bias of market action……..so in a nutshell our decision is based on a simple question of ‘what causes non-random collective participant action to dominate’?……..and so the game of speculation begins taking us down the many roads to exploiting arbitrage.
Of course humans and the human mind that give rise to the decision to interact are not as simple and straight forward as bees or starlings but there are commonalities. We have cities but those cities are not as uniform as beehives or the behavioural mechanics of swarms of birds or fishes, but there is ‘enough’ common characteristics to create the analogy. The differences are sufficient however to compound the complexity of the financial system to make it one of the toughest systems to crack.
There are many trading systems, but not many with an enduring edge. The complex and adaptive nature, particularly of the financial markets necessitate that our edge is defined with simple but enduring rules that capture the broad outcomes of complexity. This is not a game for those that like preciseness given the undercurrent of randomness that coexists in the market.