Exploring the Nature of Trader Intuition
Abstract (Via JFA)
Experimental evidence has consistently confirmed the ability of uninformed traders, even novices, to infer information from the trading process. We hypothesized that ToM was involved after contrasting brain activation in subjects watching markets with and without insiders. ToM refers to the innate 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 with reading markets when there are insiders.
Findings (Vai JFA)
Our findings should inspire research to improve visual representation of order and trade flow. Since humans often are best at recognizing the nature of intention in moving (animate or inanimate) objects [Heider and Simmel (1944), Castelli, Happe, Frith and Frith (2000)], we suggest that traders may be more likely to successfully detect insider trading when order and trade flows are presented in a moving display, as opposed to the purely numerical listings commonly found in the industry. Our (untrained!) subjects were successful in forecasting price change in the presence of insiders (on average, they performed significantly better than the best naïve strategy). One may wonder whether this success should be attributed to our using a purely graphical interface, where order and trade flows are translated into movement of circles of various sizes and colors.
Finally, the finding that markets with insiders prompt people to use a skill (ToM) that they are generally good at, may explain the popularity of betting and prediction markets, where information asymmetries abound. Uninformed participants may feel confident that they will detect insider trading when it emerges. It may also explain why people are willing to participate in markets that require advanced problem solving skills even when they know that there are others in the marketplace that are better [Meloso, Copic and Bossaerts (2009)]. ToM by itself cannot explain, however, why people want to participate if such markets constitute zero‐sum